Draft No. 4, by John McPhee

It takes what it takes” (William Shawn, former editor of The New Yorker)

Get that boy from the Old Vic” (Winston Churchill, referring to Richard Burton)

Write on subjects in which you have enough interest on your own to see you through all the stops, starts, hesitations, and other impediments along the way” (John McPhee)

Draft No. 4. On the Writing Process is a must-read—an overly-used adjective that nevertheless finds a worthy subject here—for anyone that writes non-fiction. McPhee, its author, is an American writer considered one of the pioneers of creative non-fiction. He has been writing for The New Yorker since the 1960s.

In Draft No. 4, he explores different aspects of writing—structure, editors, omission, and more—drawing on his vast experience and with his unique style. It’s like peeping behind a magician’s stage, glimpsing, and even understanding, albeit just superficially, how the trick is done. Yes, I understand that you take the card and place it in your pocket; I am still unable to do it myself though.

Trying to say anything more would be doing a disservice to this book. Read it. Read it even if you do not know—I did not—who John McPhee is. Read it even if you are not very familiar—I am not—with The New Yorker. This book brings the concept of craft to a different level. Reading through the way McPhee composes a piece, one realises how much there is to improve. It is, in a sense, reassuring: there is no need to worry about reaching the destination any time in this life.

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Arbitrage in SME lending

One of the big concerns of the aftermath of the Covid-19 crisis is that the recovery might take much longer because many firms, particularly small and medium (SMEs), will have closed down for good. From the very beginning, different actions by governments and central banks tried to make sure that SMEs did not suffer a reduction in credit. For instance, the Bank of England put in place a Term Funding Scheme (TFS) to provide cheap funding to banks, and the amount that banks can borrow from this scheme is proportional to the amount of lending that they provide to SMEs. The idea is then that banks can borrow very cheap from the central bank if they in turn provide credit to SMEs.

But of course there are limits to this policy. Even if banks keep lending to SMEs, these firms will suffer losses—many of them are temporarily closed—and hence the risk that they are unable to pay back the credit, even when this credit stays constant, increases as the lockdown remains. Banks have to consider these risks: their provisions and capital should go up to cover the increase in potential losses. This has been a source of concern at the Bank of England.

Nevertheless, the UK government has introduced a different scheme, Bounce Back Loans. These loans provided by banks but fully guaranteed by the government—if firms cannot repay, the government will. Given the maximum size of the loans, £50,000, they are designed for small firms. These are, hence, additional incentives for banks to lend to SMEs.

How do both schemes interact? Well, in the last days the Bank of England has provided some interesting information on this regard. First, bounce back loans can have a maturity up to six years, while, originally, the maximum term in the TFS was four years; the Bank of England has announced that it will be possible to extend the funding to match the maturity of the bounce back loans.

This way, banks can borrow very cheaply from the Bank of England scheme and provide bounce back loans to small firms. But what about capital requirements? There is a part of capital regulation that covers credit risk mitigation, which is the situation where the borrower obtains guarantees from a third party to repay the loans. Exactly as bounce back loans. Again, here the Bank of England has clarified that this can be done and hence banks can provide these loans at essentially zero risk weights; in other words, these loans carry no capital requirements.

Yet the 2007-08 financial crisis showed the limits of risk-based capital regulation; for this reason, policy makers around the world introduced the leverage ratio, a capital regulation that does not depend on the riskiness of bank’s assets, only on its size. I have talked about it extensively (here, here, here, here). Even if risk weights on these loans are zero, they would still affect the leverage ratio. However, the Bank of England has announced that these loans will be exempt from this regulation; more precisely, these loans will not be added to the “Leverage Exposure Measure”, which is the denominator of the leverage ratio.

Therefore, banks have a fantastic arbitrage strategy that consists on providing loans to SMEs with the full guarantee of the government and fund these loans using funding from the Bank of England just slightly above the Bank Rate (at the moment, the Bank Rate is at 0.1%). The only limit to this strategy is the amount of eligible collateral of the bank. Other than that, capital and leverage requirements are not binding, and from the point of view of liquidity requirements, this strategy is also neutral (the funding is quite long-term).

What are the risks? For the banking sector, none, as long as the UK government maintains its solvency. And this is key. The current framework assumes that the main problem of non-financial corporations is liquidity, not solvency. But this is not at all clear. For sure, liquidity is an issue, but so is solvency, especially for some sectors. What happens if a big part of these guarantees end up realising? The government debt would increase even more. It is not unthinkable that the UK might lose the double-A credit rating in the near future. And all this while negotiating the new deal with the EU.

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Limiting borrowers leverage

In the last post I talked about the countercyclical capital buffer (CCyB), a new regulatory tool to increase banks’ capital requirements that most countries have not used but that could have been effective to mitigate the Covid-19 crisis. As I mentioned there, the UK did use it, albeit not to the full extent. But the UK has used other tools to try to limit the buildup of risks; one of the most important ones is a tool limiting the number of high loan-to-income mortgages.

Loan-to-income (LTI) indicates how big is the mortgage debt relative to the annual income of the borrower. If someone earning £60,000 a year takes a £240,000 mortgage to buy a house, then the LTI is 4. The higher the LTI, the higher the leverage borrowers are taking. And the higher the amount borrowed with respect to income, the more consumption responds to changes in aggregate conditions. The reason is that borrowers adjust their consumption in order to reduce the possibility of default, especially in countries with full-recourse, such as the UK. The chart below presents evidence that higher LTIs were associated with stronger reductions in consumption during the financial crisis (even when normalising by income). The chart is taken from the Bank of England’s December 2019 Financial Stability Report.

Consumption

Therefore, reducing mortgages with high LTIs should lead to a smaller adjustment during a crisis. I am not going to discuss here the differences between the Covid-19 and the financial crises—for instance, consumption is going down mostly because of the quarantine, not because unemployment is going up. The point is to highlight another measure introduced by the Bank of England in 2014: a limit on the number of mortgages with LTI equal or above 4.5 that lenders can grant. If this measure indeed limited this type of mortgages, then this might improve consumption during the Covid-19 crisis.

The evidence from the distribution of LTIs before and after the policy was introduced is consistent with the idea that it limited high LTI mortgage lending. In the chart below (taken from the July 2016 FSR) we can see that although the distribution has shifted right (compared to 2014Q1), the frequency of mortgages with LTI above 4.5 has decreased. To the extent that this reduction would not have happened without the policy (luckily we will share some evidence backing this claim up soon) then the adjustment in consumption during this crisis might be lower than what would have happened without the policy.

LTI_Distrib

In general, one of the issues with this type of intervention (which we broadly call “macroprudential policy”), is that one can only empirically assess the “costs” while the economy is growing well; costs, for instance, would be a reduction in mortgage lending. It is precisely only during a crisis, or at least a change in the cycle, where the benefits of this policy start to show. This is one of the reasons why we see a weakening of the regulatory framework as the economy recovers and grows healthily. This Covid-19 crisis might in fact stop this trend and reinforce the importance of macroprudential regulation.

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Countercyclical capital buffers and regulatory discretion

One of the main regulations that banks have to comply with are capital requirements; in particular, banks need to hold a minimum amount of capital depending on the composition of their investments (assets). Actually, the use of the word “hold”, although quite common, is slightly misleading: capital is a source of funding for the bank—to be precise, an internal source of funding—so it is not something that banks hold, like cash. This short video discusses the concept.

There are several rationales for subjecting banks to such regulation. An obvious one is the fact that bank defaults (what happens when they run out of capital) impose very high costs to the economy; in other words, there are negative externalities that banks do not internalise. The way to design capital requirements, however, is far from obvious. In fact, just in 2007, right before the financial crisis, banks look sufficiently capitalised, at least according to the regulatory framework in place at that time. But they were not. Lack of liquidity, for instance, can lead to insolvency. Off-balance sheet exposures might become on-balance sheet very fast. Another lesson learned from the crisis was that risks build up during the boom and then materialise in the bust. Therefore, requirements should be increased during a boom—although it looks like risks are low—to protect the banking sector, and the real economy, when things go south.

One of the main new tools to deal with this time-varying dimension of financial risks is the Countercyclical Capital Buffer (CCyB). The idea is exactly as stated below: the macroprudential authority of the country should increase the buffer when the economy is doing well and reduce it in the opposite case. This post in the St. Louis Fed explains it well. For instance, right now, with the Covid-19 pandemic, is the moment to reduce it. The problem faced by many countries, however, is that they had not even activated in the first place. And this points towards a strong limitation of this tool that hopefully could be reformed in the near future.

As of October 2019, only 10 out of the 31 countries in Europe had positive CCyB. 6 of them had it at 1% or less. Only Sweden had a CCyB at its maximum level under European legislation, 2.5%, while Norway had it at 2%. UK had set it at 1%. The UK is, in fact, a good example to illustrate how the decisions to increase and decrease it are taken.

In its meeting in March 2016, the FPC—the macroprudential regulator in the UK—decided to increase the CCyB from 0% to 0.5%. Because it takes one year to become effective, the increase would take place in March 2017. However, after the EU referendum in June 2016, the FPC decided to bring it back to 0%. The reduction, contrary to the increase, is immediate. In other words, the CCyB never moved. There were no changes until July 2017, when the FPC increased it to 0.5% (effective July 2018) Then, in November 2017, it was decided to increase it to 1% (effective November 2018).

So what was the actual CCyB since January 2016 until March 2020? Well, it increased to 0.5% in July 2018 and to 1% in November 2018, coming back to 0% last month due to the pandemic. Hence, in the last four years, the UK had positive CCyB for just over a year and a half. And this in a period where credit was growing well…

Credit_growth_UK

… and lending spreads were at their lowest since the financial crisis.

Spreads_UK

And the UK is one of the (few) countries that appears interested in using this tool. This situation looks quite opposite to the stance that regulators took early in the Basel III discussion times. In December 2009, the BCBS published a document presenting the proposals from the committee to strengthen the resilience of the banking sector. One of the points was dedicated to reducing the pro-cyclicality of the financial sector.

The financial sector can be very pro-cyclical. What that means is that, during a boom, the growth of the economy if even higher since the financial sector provides cheap credit; however, during the bust, the recession is deeper because the financial sector stops lending and potentially hoards cash. It turns out that some parts of the banking regulation actually increase this pro-cyclicality. Hence, it appeared important to re-design some aspects of it as well as providing some tools to mitigate the pro-cyclicality.

Among the potential re-designs there are things such as making the minimum capital requirements—i.e., those that are not increased or decreased through the cycle—less pro-cyclical. Repullo and co-authors showed that capital requirements for the same mortgage portfolio can vary up to 50% through the cycle. Although some changes have been introduced in Basel III—for instance, input floors—which should reduce pro-cyclicality, this was not their main goal.

Another proposal was the use of dynamic provisioning. This is a regulation that was introduced in Spain in the year 2000, and even though it was not enough to fully protect the banking sector, the consensus is that it saved a substantial amount of tax-payer’s money. Unfortunately, this idea was dropped early on at Basel, likely due to the strong heterogeneity among member countries regarding provisioning practices.

At last, we ended up with just countercyclical capital buffers, and with sever limitations. The maximum amount is 2.5% over RWAs. Yet, banks face at least a 7% requirement at all times—plus any supervisory addition—so the CCyB represents at most increasing requirements by a third. Given the volatility of credit cycles, coupled with the huge costs from financial crises, it is strange that this requirement is less than, say, 50% of total requirements.

But the other limitation is probably more serious: national authorities have discretion over when to activate it. Although it is difficult to come up with a set of rules about when to raise or reduce it, discretion has led to most countries having it at 0% before the Covid-19 pandemic, even though several countries in the EU were growing relatively well in the recent years.

How different would have been if, say, the CCyB could go up to 4-5% of RWA and national authorities would be required to increase it when credit is growing well? Many banking regulators would have room to free up bank capital which could be used to keep lending to firms with problems to repay, even if this increases credit risk. The opposite of what we have.

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Moralities of everyday life

What is morality? Why do we feel disgust towards certain actions? Does everyone have a different morality? Should we be moral? How should we determine what is the moral thing to do? These and other questions are discussed in the course “Moralities of everyday life“, which can be taken for free in Coursera. The instructor is the wonderful Paul Bloom, Professor in Psychology at Yale. I knew Paul from his recurrent chats with Sam Harris at the Making Sense podcast first, and then from reading his book Against Empathy. But I have rediscovered him as a teacher, and a great one at that.

Bloom starts by introducing two main sides of the morality debate: utilitarians and Kantians. He does not talk much about Aristotle, which one could think of as the “third” camp, although he does mention him. He does a great job of mentioning the shortcomings of both approaches, although he, like me, is more in the utilitarian—or consequentialist—side. He talks about the role of emotions in morality, empathy, psychopathy, evolution of morality, …the course is extraordinarily rich, and I am only in Week 3 of 6.

The readings for the course are very interesting as well. While the lectures mention several scientific studies—I particularly like the one on how inducing disgust via smell leads to judging certain acts as less moral—the readings are more for a general audience. The authors are people such as Steven Pinker (who was his PhD advisor), Sam Harris (his Ted Talk on the Moral Landscape), Jonathan Haidt, Peter Singer, Dan Ariely, Jon Ronson, Richard Dawkins, Robert Wright, or Steve Levitt. All these authors are incredible communicators of science.

I cannot recommend this course enough. The first reason is because it is completely free; the second because some people might have a lot of time now that we can barely leave our homes. But the third and most important one is the need for us, humans, to understand where morality comes from; to understand why we feel outrage, why we see others as enemies; and to learn how to let this feeling subside and think about ethics and morality more rationally.

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Keeping at It, by Paul A. Volcker

Paul Volcker, who died this last December at the age of 92, is some sort of almost demi-god among people interested in central banking, monetary policy, and banking regulation; in other words, people like me. I was hence extremely interested to read his memoir. In Keeping at It: The Quest for Sound Money and Good Government, Volcker explains how he lived episodes such as the fall of Bretton Woods, the fight against inflation in the late 70s and early 80s, the Latin America crisis in the 80s, the 2007-08 financial crisis and the subsequent regulatory reform—including the so-called Volcker Rule.

It is not that Volcker lived throughout these moments; he was actually the main character in many of them. But apparently he did more, much more. For instance, he chaired one of the investigations to determine the number Jewish dormant accounts in Swiss banks. Jews fleeing due to the Holocaust deposited money in the Swiss banking sector taking advantage of its position as a neutral country; however, after the war, they faced a lot of obstacles—mostly bureaucratic imposed by banks—to get the money back. He also chaired an investigation into the United Nations’ Oil-for-Food program in Iraq. He chaired the foundation of the IFRS, the body that sets accounting standards worldwide. And he went to become economic adviser of Obama. Not too bad.

The memoir is focused mainly on the professional side of Volcker, and while it is not a brilliant literary piece, it is sufficiently well written, and his professional life was incredible, so this turns out to be a wonderful—and relatively fast—read.

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My books: A tour

I am running out of activities to do with my (almost) three-year-old daughter, so I decided to sort my books by topic and alphabetical order. It looks so nice that I decided to record a brief tour around them. Here it is:

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The Fifth Risk, by Michael Lewis

When I was at the Bank of England, I remember discussing with someone over a coffee about the need to screen new candidates for a willingness to work as public servants. The idea—as argued by my counterpart—was that people who work for the public sector should have some sort of trait(s) that makes them suitable for that sector. I thought that made no sense. Why would you purposely limit the pool of potential candidates? It is not as if it was easy to attract new PhDs; on the contrary, the low pay—compared to other finance departments and central banks—and the reputation of the institution regarding the little importance placed on research—a reputation that has improved substantially since Mark Carney became the Governor—made it challenging to hire.

But that was the whole point. If you do not screen for such candidates, the ones that come to the public sector might leave shortly afterwards. And hence the recruitment process needs to start again. Without entering into a discussion of how to screen them, it now appears clear to me that this should be one of the most important selling points of the Bank of England when recruiting: come to develop your research, not only to satisfy intellectual curiosity, but importantly to improve policies and help maintain financial stability and prosperity.

The subjects that serve the public are the main focus of the latest Michael Lewis’ book, The Fifth Risk. The author highlights the career and work of (many former) employees of the Federal Government and their crucial contribution in different areas such as nuclear power, weather forecasting, or sea rescues. And, importantly, details the new Trump Administration’s approach—or lack thereof, to be more precise.

As seen with the Coronavirus pandemic, Trump is completely unprepared for his job. While he might not be the first President to be unfit for office, a crucial difference with Trump is that he is not even able to recruit people that will do a good job. His ego and insecurities are so big that he needs people around telling him how good he is. He has the opposite of a civil servant mentality; it’s all about him. And one of the consequences is that he cannot understand how vital certain parts of the government are. Not only is he unfit for office, but also he thinks he is the most fit for it. The danger that this produces is huge.

I have tended towards more libertarian positions for many years now. I do not consider myself a libertarian—I might have, in the past—but my “default” position in most cases is no government intervention. There are many reasons for this, and I think this is not only a defensible position, but actually the most rational one. Of course government intervention is necessary; unfortunately, ex-post rationalisation of moral urges provide cover for interventions that are misplaced and can create dangerous precedents. My favourite example is the banning of the Niqab or the Burqa.

And yet I have felt extremely sympathetic with the main characters in The Fifth Risk. Maybe it is because they remind me of my mother. She was a primary school teacher for several decades—she has retired now. She used to bring work at home; exams to mark, activities to prepare, etc. Don’t get me wrong: she managed to do everything—this is not a story of absent mothers. But early on what I thought was: Why are you doing this? Your salary does not depend on this additional effort. I think this is what I find so compelling about some of the examples: they just do their job as best as they can, saving lives as a result, without any apparent private benefit. Many of them could clearly be making a lot more money… but they choose not to.

Anyway, as usual, these posts are less about the book and more about my thoughts. It is an interesting book, recommended, although nothing close to Liar’s Poker, Flash Boys, or The Big Short. Those are masterpieces!

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National Populism, by Eatwell and Goodwin

National populists prioritize the culture and interests of the nation, and promise to give voice to a people who feel that they have been neglected, even held in contempt, by distant and often corrupt elites.

The result of the Brexit referendum and the election of Donald Trump as the 45th President of the United States took many people, particularly from the economic and political elites, by surprise. But I predicted it! No, of course not. I was as surprised—shocked might be a better word—as everyone else around me. But the movements towards more populist positions have been increasing for some time. And the book by Roger Eatwell and Matthew Goodwin, National Populism, is an excellent source to understand why.

One thing that I particularly enjoyed of this book is that the authors analyse the issues without any judgement or moral outrage. To say that this is refreshing is an understatement; it has almost become a meme to say that the Leave voter was an older uneducated racist white living in the countryside. And, for sure, all these variables correlate positively with a vote for Leave. But the model still leaves a lot of unexplained variation. Getting a deeper understanding of this variation is key; if not for pure intellectual curiosity, at least to “win back” part of these voters.

The book claims that the increase of national populism revolves around four Ds: Distrust, Destruction, Deprivation, and De-alignment. Distrust refers to the lack of trust that citizens feel towards the elites–as Michael Gove put it during the referendum campaign, Britain has had enough of experts. (Although they seem to be back with the Coronavirus!). Destruction is related to the perceived elimination of the nation’s historical identity. There are many examples of this, such as John Cleese saying that London is no longer an English city. Deprivation describes the belief that one collective is losing out relative to another. Finally, de-alignment refers to the lost bonds between voters and parties, citizens and mainstream media.

I would add, as the book points out, that the reaction to these concerns by a part of the media elite reinforces the position of national populists. Take the case of John Cleese’s claim. I like London a lot, and one of the main reasons is the fact that it is extremely cosmopolitan, with plenty of people coming from other parts of the world, a great mix of cultures and traditions. This fact, by definition, means that it is less English. In the 2011 census, the percentage of foreign-born population living in Inner London was 42.2%. Of course, someone could argue that Cleese is trying to create an us-vs-them mentality, de facto implying than non-English is worse, and hence the comments are clearly racist. Maybe that was his intention; maybe not. But the reaction is to attribute this intention to anyone that makes this type of claim. And when this is the reaction to self-evident truth (more and more non-English people have come to live in London, and hence the English tradition and identity of the city is diminishing) we end up with populist leaders gaining more trust from the voters.

There is much more in the book that I am not going to try to cover here. But an important point is that national populism appears to be here to stay. This is not just a temporary shock that will go away as people realise their “mistakes.” The underlying concerns will continue and most likely exacerbate in the next years, with raising inequalities, automation, and public spending restrain. Therefore, it is key to start thinking about how to address them so that national populist leaders do not get to decide the fate of the nations.

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Sapiens, by Yuval Noah Harari

… we are on the threshold of both heaven and hell, moving nervously between the gateway of the one and the anteroom of the other. History has still not decided where we will end up, and a string of coincidences might yet send us rolling in either direction.

Better late than never, I just finished reading Sapiens. The book is an account of our history, the history of Homo Sapiens, from the beginning—when other species of humans shared the Earth—until now. I’ll start by saying the obvious: this book should be completely mandatory in school; if not the book itself, the content for sure. When I look back at my education, I wonder why we had to spend time studying the history of Catalonia and Spain while so much about our human history was left out. Admittedly, Harari would say that this is necessary for the fiction that we call “nation” to persist, but it is not clear to me why we should not push for a bigger tribe.

Anyway, this is a discussion for another time. The book is extremely interesting and enjoyable; I thought I would quickly summarise three ideas / facts that I found remarkable:

  • There are several species of humans that became extinct in the past. While I knew that to be the case for the Neanderthals, there are a few more that were scatter across the globe, such as Denisovans or Soloensis. While some of their DNA is now mixed with ours—meaning there was at least some inbreeding between species—it still seems to be the case that Homo Sapiens drove them to extinction—although maybe not on purpose.
  • The idea of hunter-gathering tribes being somehow “on-balance” with nature is, to put it mildly, laughable. The amount of animal species that we destroyed or permanently changed during that period is immense. True, these Sapiens did not have the knowledge to understand the consequences of their actions, so I am not judging them—I’m judging those who, nowadays, with all the current knowledge in their hands, idealise that period.
  • The agricultural revolution can be seen as plants—wheat, rice, etc—domesticating Homo sapiens. The fate of the family or the village depended on whether the crops were abundant. The rise in welfare did  not come until centuries later.

I highly recommend it for anyone interested in our history… so, basically, everyone. A final note: maybe it is because I read about the Coronavirus every hour of every day, but I keep relating the books I read to the current situation. The quotation at the beginning of this post marks the times that we are living in. The world in the recent decades has improved dramatically. Among other things, international conflicts have decreased to a minimum. The strong links among countries—in terms of trade, finance, even culture—make it more difficult to have conflicts like in the past. Yet this new pandemic is threatening to separate us from each other, at least temporarily; we are starting to see countries blaming other countries for the virus—even suggesting that it was developed on purpose. As the links among countries are momentarily reduced, let’s try not to revert back to a past where clashes against other countries were incessantly used to strengthen the concept of the nation.

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