Five comments on Patrick Jenkins “Failure to learn lessons of 2008 caused LDI pension blow-up”

Five comments on Patrick Jenkins “Failure to learn lessons of 2008 caused LDI pension blow-up”. Not sent by a letter to the Financial Times.

“There’s no such thing as risk-free” 

Especially if you take into account that e.g., major bank crises always result from the build-up of dangerously excessive exposures with assets perceived or decreed by regulators as especially safe.

“Ultra-low interest rates have obscure side-effects”

Indeed, especially when those ultra-low interest rates are the result of manipulations. The current risk-free rate has nothing to do with the risk-free rate before risk weighted bank capital requirements and QEs.

“A leveraged bet — to ‘juice’ otherwise low returns”

“Assets assigned the lowest risk, for which bank capital requirements were therefore nonexistent or low, were what had the most political support: sovereign credits & home mortgages...A ‘leverage ratio’ discouraged holdings of low-return government securities” Paul Volcker

“In the UK, the government wants to make it easier for pension funds and life insurers to invest in riskier assets”

And it should be done, but only by removing the artificialities that have pension funds, life insurers and banks investing excessively in “safe” assets.

“Amateurish governance is dangerous. One of the lessons of bank failures in 2007-8 was that expertise matters”

No! Trusting too much the expertise, e.g., credit rating agencies, introduces a much more dangerous systemic risk.

And I could make many more similar comments.

If we want public debt to protect citizens today and tomorrow, it behooves us to make sure it cannot be too easily contracted.

Sir, I refer to John Plender’s “The virtues of public debt to protect citizens” FT February 7, 2022.

Sir, as a grandfather I do fear debt burdens we might impose on future generations, but I’m absolutely not an austerity moralist. I know public debt is of great use if used right but also that the capacity to borrow it a reasonable interest rates (or the seigniorage when printing money), is a very valuable strategic sovereign asset, especially when dangers like war or a pandemic appear, and which should therefore not be irresponsibly squandered away.

In 2004, when I just finished my two-year term as an Executive Director of the World Bank, you published a letter in which I wrote “Our bank supervisors in Basel are unwittingly controlling the capital flows in the world. How many Basel propositions will it take before they start realizing the damage, they are doing by favoring so much bank lending to the public sector?”

1988 Basel I’s risk weighted bank capital requirements decreed weights of 0% the government and 100% citizens. It translates into banks being allowed to hold much less capital - being able to leverage much more, with loans to the government than with other assets.

Of course, governments, when their debts are denominated in the currency they issue, are, at least in the short-term and medium term, and in real terms before inflation might kick in, less risky credits. But de facto that also implies bureaucrats/ politicians/apparatchiks know better how to use taxpayer’s credit for which repayment they are not personally responsible for than e.g., small businesses and entrepreneurs. And Sir, that I do not believe, and I hope neither you nor John Plender do that.

Such pro-government biased bank regulations, especially when going hand in hand with generous central bank QE liquidity injections, subsidizes the “risk-free” rate, hiding the real costs of public debt. In crude-truth terms, the difference between the interest rates sovereigns would have to pay on their debts in absence of all above mentioned favors, and the current ultra-low or even negative interests they pay is, de facto, a well camouflaged tax, retained before the holders of those debts could earn it.

But of course, they are beneficiaries of all this distortion, and therefore many are enthusiastically hanging on to MMT’s type Love Potion Number Nine promises.

@PerKurowski

It’s not the role of regulators and central banks to help governments fund their operations, behind the back of citizens

Sir, Kate Allen writes that “euro-area financial institutions” have reduced their holdings of public debt “17 per cent in the past two years [but] the ECB made nearly €1.5tn of cumulative net purchases of eurozone public sector bonds through its quantitative easing programme — effectively replacing the purchasing role that banks had played. “Post-crisis reforms force European governments to curtail size of debt sales” January 5.

It all forms part of the same statist subsidizing of public debt. 

What would sovereign rates be if banks had to hold the same capital against sovereign debt than against loans to citizens; and if ECB had not purchased “eurozone public sector bonds through its quantitative easing programme”? The answer would have to be rates much higher, which would send quite different risk-free-rate signals.

In 1988, with Basel Accord, statist regulators, with their 0% risk weighted bank capital requirements, began subsidizing immensely government borrowings. When the 2007/08 crisis came along, central banks, perhaps in order to hide own their regulatory failures, with their quantitative easing purchases generated, wittingly or not, new sovereign debt subsidies.

This has dramatically changed the economical relations between governments and private sectors. It amounts to statist hanky-panky behind the backs of citizens. Since besides needing servicing it consumes, for nothing really special, sovereign indebtedness space that could be urgently needed tomorrow, it might become deemed as high treason by future generations. Where this is going to end is anyone’s guess, but it sure won’t be pretty.

@PerKurowski

Risk-weighted capital requirements for banks favoring the sovereign, artificially lowers the neutral/risk-free rate

Sir, Chris Giles writes: One “fundamental problem in central banking is that estimates of the neutral rate of interest — seen as the long-term rate of interest that balances people’s desire to save and invest with their desire to borrow and spend — appear to have fallen persistently across the world.” “FT Big Read. IMF Meetings: Setting policy in the dark” October 12.

That has an explanation:

Banks are allowed by the regulators to hold less capital against loans to the government (sovereign) than against loans to the private sector.

That means that banks are allowed to leverage more with loans to the government than with loans to the private sector.

That means that banks can earn higher risk-adjusted returns on equity with loans to the government than with loans to the private sector.

That means that banks, when compared to what they would have done in the absence of these distortive regulations, lend more to the government and less to the private sector; especially to the “riskier” part of it, like unrated SMEs or entrepreneurs.

That means there is a downward pressure on the interest rate on loans to the government, and, since these signify for the most a reference of the risk-free rate, that pulls all rates down from what should be their ordinary level.

And when that regulatory pulling down of rates is topped up with central banks with their QEs loads of government debt, the drop in the “risk-free” floor rate becomes truly important.

Sir, IMF and central bankers have been blind for a very long time to the distortions produced by the risk weighted capital requirements for banks.

Now and again they seem close to understanding it, like last November during IMF Research conference, but then they lose themselves again.

I guess, as Upton Sinclair Jr. said, “it is difficult to get a man to understand something when his salary depends upon his not understanding it.”

Now the real problem for me with central bankers goes way beyond this issue of the neutral interest rate.

My problem is that central bankers never resolved anything, they just kicked the 2007-08 crisis can forward, and basically left in place the distortions that produced it. So therefore a new crisis, could be an augmented one, just lurks around the corner. Great job guys!

And of course, with respect to central bankers pursuing an inflation marker, like in a greyhound race these pursue an artificial hare, I can’t but agree with Daniel Tarullo’s “Essentially you are setting policy on things you don’t know and can’t measure and then reasoning after the fact”.

@PerKurowski

The interest rates on public debt are distorted by QEs and bank regulations. Seemingly no one dares to research that

Sir, Baroness Ros Altmann, when commenting on Martin Wolf’s (“Capitalism and democracy are the odd couple” of September 20, writes:

“Global central banks have artificially distorted capital markets for several years, by creating vast amounts of new money to buy sovereign debt. The supposedly “risk-free” interest rate, on which much of the system depends, has been undermined (and she concludes)… it is important to consider the democratic dangers to capitalism which prolonged QE may pose. ” “Disguised fiscal measures play role in democratic recession” September 22.

She is absolutely correct, and I have over the years written for instance Martin Wolf numerous letters on it.

But there is also the regulatory distortions provoked by the risk weighted capital requirements for banks introduced in 1988 with Basel I, and which assigned a 0% risk weight to sovereigns.

That meant at that time, and well into current Basel III times, that banks needed to hold little or no capital when lending to sovereigns; meaning banks were authorized to leverage immensely when lending to sovereigns; meaning banks could earn fabulous risk adjusted returns on equity when lending to sovereigns; meaning banks would lend too much and at too low rates to sovereigns.

So, when to QEs we add this through-the-back-door regulatory subsidies to government borrowings from banks (and now with Solvency II extended to insurance companies) it is absolutely clear we have no idea what the real cost of public debt is; and so we are all flying blind… and government bureaucrats having much easier access to bank credit than SMEs or entrepreneurs.

Last November, during IMF’s Annual Research Conference, I got at long last one of the major experts, in this case Olivier Blanchard, to agree with me in that “lets make sure that we have removed all the distortions which we can, which affect r (rates), so we have the right r”.

Sir, as of this moment that was the last time I have heard about it.

Why is there no response? Perhaps the answer is found in Upton Sinclair’s “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

PS Here is the link to my own response to that particular article of Martin Wolf

@PerKurowski

The Sovereign’s footmen, the regulators, are force-feeding the economy public debt. When will the liver explode?

Sir, Sam Fleming and Robin Wigglesworth report: “The Fed will need to operate with a much larger balance sheet than before the crisis — at least three times as big, say some investors — in part because of regulatory and other changes governing institutions’ appetite for safe assets” “Fed edges towards paring back its balance sheet” May 2.

Of course, in 1988 the Sovereign had his bank regulation footmen declare him risk free, 0% risk weight, while the citizens, they got a 100% risk weight.

When kicking with QEs the 2007/08 crises can down the road, the Fed as well as some other central banks, purchased enormous amounts of public debt.

With Basel III the regulators kept going at it introducing liquidity requirements that much favored “marketable securities representing claims on or guaranteed by sovereigns”.

Insurance companies’ regulators, with their Solvency II, are closely following the same path.

Now when they are thinking of reeling the 2007/08 can in, to sort of prepare for the next crisis, how is the Fed to do that? Well the authors report that accordingly to Mr Rajadhyaksha, head of macro research at Barclays: “Assuming that it wants to get rid of all its $1.8tn of mortgage bonds as it retreats from the home loan market, it may have to start buying Treasuries again at the tail-end of the process” which means more sovereign debt will be purchased.

In other words the Sovereign’s foot soldiers are de facto force-feeding public debt down the economy’s throat. When will the economy’s liver explode?

And the craziest thing is that most experts still take the interest rates on such debts to be market fixed, and to reflect the real risk-free rate.

How could so much statism have been injected in our system without it being noticed?

This statism de facto presumes that government bureaucrats know better what to do with credit than the private sector. That presumption leads of course to disaster. 

We now read in IMF’s Fiscal Monitor 2017 (page x), with IMF acting like the Sheriff of Nottingham for King John, that “the case for increasing public investments remains strong in many countries in light of low borrowing costs” and that “the persistent decline in the interest rates may have relaxed government budget constraints in advanced economies; if the differential between interest and GDP growth were to remain durably lower than it has been in past decades, countries could be able to sustain higher levels of public debt.” “Low borrowing costs” IMF? Do your research and dare to figure out why. Others are paying for that by having less access to credit.

Sir, IMF has the galls to title 2017 Fiscal Monitor as “Achieving More With Less”, while completely ignoring that over the last decades, Sovereigns, have been Achieving So Much Less With So Much More.

@PerKurowski

Basel Accord’s risk weights subsidized sovereign bonds, so since then these were no longer proxies for risk free rates

Sir, Michala Marcusssen argues that because of quantitative easing and negative interests “the proxies of sovereign bond yields for the “risk-free” rate of return is becoming an increasingly imperfect substitute with potentially dangerous consequences” “The demise of the ‘risk-free’ rate in markets”, June 14.

Marcussen refers to “a new debate on how to treat sovereign debt on bank balance sheets. At present, sovereign debt enjoys favourable treatment not just in the euro area but across the globe. Basel III allows (but does not mandate) a capital requirement of 0 per cent for sovereign bonds”

Not exactly, as I have often written to FT, the problem of a not valid proxy for the risk-free rate originated much earlier, soon 30 years ago.

The Basel Accord of 1988, Basel I, set the risk weights for sovereigns at zero percent and that of citizens at 100 percent. Since that signified a regulatory subsidy of sovereign debt, ever since we have not have had a reasonable proxy for a risk free rate.

Of the demand for sovereign debt, how much comes from the free market, and how much from regulatory distortions?

Sir, Dave Shellock writes that among other, because of the possibilities of Brexit, and because of Fed’s Janet Yellen’s dovish speech, “Sovereign debt demand drives benchmark yields to record lows” June 11.

When will someone try to figure out how much of that demand for sovereign debt has been artificially inflated by regulations? For instance banks are allowed to hold the least capital against sovereign debt, and knowing about the general scarcity of bank capital that must influence its demand very much. And similarly others, like the insurance sector, have been nudged in many ways to hold sovereign debt.

The day banks and insurance company are allowed to hold private sector assets under the same conditions they can hold sovereign debt, then we would be able to know what the free market really indicates.

Sovereign debt, like US Treasury and bonds, are most often used as proxies for the all-important “risk-free rate”. Sir, it is therefore really hard for me to understand why the possibility we might not have a true risk-free rate proxy, because the rate of US Treasuries and bonds are subsidized by regulations, is not of any interest to the Financial Times. It is like a National Geographic not being interested in the earth's rotation being shifted.

@PerKurowski ©

Today’s “risk-free-rates”, are not real risk free rates but subsidized risk free rates!

Sir, I refer to Amin Rajan’s “Portfolio theory has hypnotised asset managers” January 19.

Rajan, referring to Pascal Blanqué’s book “Essays in Positive Investment Management” writes:

“In practice, from 1999 to 2009, US 10-year Treasury bonds not only outperformed risky assets such as equities, their actual returns were also well above the expected ones. In fact, government bonds have violated every tenet of conventional investment wisdom over the past 30 years…

So what is the solution? The author is at pains to point out that there is no silver bullet. Our current knowledge of how markets operate is very limited. There is a crying need for more research and debate.”

Sir, when markets finally get to understand that the interest rates sovereigns are paying, is not just a consequence of their perceived “infallibility”, but also a result of them having awarded themselves regulatory subsidies… it might be too late… and all hell might break loose.

Here is the story. In the early 90s with Basel I, and then with Basel II, and currently with Basel III, banks need to hold very little or no equity at all when lending to the sovereigns, especially when compared to what they are required to hold when lending to “risky” citizens.

And that means: the more problem loans eats up bank equity; and the more regulators require banks to hold more equity; and even the more bank are fined (which eats into their equity)… the more will the banks de facto be forced to hold sovereigns.

Current US Treasury bond rates, those usually used as “risk-free-rates”, are not real risk free rates but subsidized free rates!

How do you price bank credit for sustainable growth having to consider both risk profiles and capital requirements?

Sir, Axel Merk writes “sustainable growth comes from pricing credit correctly according to the risk profile of the borrowers, not merely cheap credit”, “The missing fear factor will return to haunt Yellen”, July 10.

Absolutely… but how do banks do that when they also must price credit according to the capital requirements ordained by the regulators for different borrowers? Impossible!

And Merk also refers to that “Forward-looking indicators, such as the yield curve, are less reliable as the Fed itself has actively managed those gauges”. Yes and here also by means of the risk-weighted capital requirements for banks, which being the smallest or even zero for “infallible” sovereign debts, has helped to convert treasury bills and bonds into a proxy of a subsidized risk-free rate.

Mr. Richard Madigan would you not like to know the real not subsidized US bond based risk-free rate?

Sir, Richard Madigan, chief investment officer at JPMorgan Private Bank writes “US bond markets leads all markets because they act as the risk-free rate for all risk-assets”, “Rate rises will come despise lower bond yield”, June .

I would love to ask Mr. Madigan the same question I asked Mr. Alan Greenspan some years ago namely… would you not like to know the real US bond based free-rate, without that regulatory distortion resulting from allowing banks to hold US bonds against so much less capital than what they need to hold when lending to citizens, and which in effect makes it therefore a subsidized free-rate?

Mr. Greenspan after hesitating for some moments advanced a "Yes".