Axel Weber of the Bundesbank Picks Up on Paul Krugman's "Non-Bank Bank Run"

Paul Kedrosky reports:

Paul Kedrosky: The First Non-Bank Bank Run: In a speech at the Jackson Hole economic conference this weekend, Bundesbank president Axel Weber did a nice put of putting into words what is really going in financial markets. Call it the first "non-bank bank run".

The current turmoil in the financial markets has all the characteristics of a classic banking crisis, but one that is taking place outside the traditional banking sector.... Mr Weber told fellow central bankers and economists at the Federal Reserve’s Jackson Hole symposium that the only difference between a classic banking crisis and the turmoil under way in the markets is that the institutions most affected at the moment are conduits and investment vehicles raising funds in the commercial bond market, rather than regulated banks. These entities were inherently vulnerable to a sudden loss of confidence on the part of their funders because “there is a maturity mismatch” on the part of financial institutions that have invested in long term mortgage-backed or asset-backed securities using short-term finance.

The ever-quotable Paul McCulley of Pimco went on to call it a "run on the shadow banking system".

As Paul Krugman put it two weeks ago:

It’s a Miserable Life - New York Times: Old-fashioned bank runs just don’t make sense these days. New-fashioned bank runs, on the other hand, do make sense — and they’re at the heart of the current financial crisis. The key to understanding what’s happening is taking a broad view of what constitutes a bank. From an economic perspective, a bank is any institution that offers people liquidity — the ability to convert their assets into cash on short notice — while still using their money to make long-term investments.

Traditional banks promise depositors the right to withdraw their funds at any time. Yet banks lend out most of the money depositors place in their care, keeping only a fraction in cash. The reason this works is that normally a bank’s depositors want to withdraw only a small proportion of their money on any given day. Banks get in trouble, however, when some event, like a rumor that major loans have gone bad, leads many depositors to demand their money at the same time. The scary thing about bank runs is that doubts about a bank’s soundness can be a self-fulfilling prophecy.... That’s why bank deposits are now protected by a combination of guarantees and regulation.... But these guarantees and regulations apply only to traditional banks. Meanwhile, a growing number of unregulated bank-like institutions have become vulnerable to the 21st-century version of bank runs.

Consider the case of KKR Financial Holdings, an affiliate of Kohlberg Kravis Roberts, a powerhouse Wall Street operator. KKR Financial raises money by issuing asset-backed commercial paper — a claim that’s sort of like a short-term C.D., used by large investors to temporarily park funds — and invests most of this money in longer-term assets. So the company is acting as a kind of bank, one that offers a higher interest rate than ordinary banks pay their clients. It sounds like a great deal — except that last week KKR Financial announced that it was seeking to delay $5 billion in repayments. That’s the equivalent of a bank closing its doors because it’s running out of cash.

The problems at KKR Financial are part of a broader picture in which many investors, spooked by the problems in the mortgage market, have been pulling their money out of institutions that use short-term borrowing to finance long-term investments. These institutions aren’t called banks, but in economic terms what’s been happening amounts to a burgeoning banking panic.

On Friday, the Federal Reserve tried to quell this panic by announcing a surprise cut in the discount rate, the rate at which it lends money to banks. It remains to be seen whether the move will do the trick. The problem, as many observers have noticed, is that the Fed’s move is largely symbolic. It makes more funds available to depository institutions, a k a old-fashioned banks — but old-fashioned banks aren’t where the crisis is centered. And the Fed doesn’t have any clear way to deal with bank runs on institutions that aren’t called banks...

Comments

[Robert Bell]

Given that Krugman published two weeks ago, who is going to get kudos for the very clever expression "non-bank bank run"?

[George J. Georganas]

The difference between banks that are called banks and all other companies (including those producing {actually intermediating between consumers and producers of} real goods and services) is that investors in bank "products" expect with reasonable certainty to get back their investment and some interest. Those who invest in all other investment vehicles have no such expectation. They have accepted the risk. As a result the financial system is so much the stronger and the economy performs much better than it would perform if all companies were to be regulated like banks. Maturity mismatch is just another word for investment.

[dsquared]

[And the Fed doesn’t have any clear way to deal with bank runs on institutions that aren’t called banks...]

Course it does. This is all in Bagehot. The discount houses weren't called banks either. The discounting of short term bills is not exactly a brand new financial innovation, is it, and nor is the phenomenon of occasional difficulties in rolling over short term paper.

The central bank should lend

a) without limit
b) against good collateral
c) at a penal rate.

by the way, I think I will lodge a claim on this particular gold mine:

http://mailman.lbo-talk.org/2001/2001-March/004695.html

[dsquared]

ach, the lbo-talk archives are down. Here's what I wrote in 2001, from Google cache:

"This might be a bit less vague; as discussed last
year, a fairly high proportion of the US' money supply
is part of an unregulated and uninsured secondary
banking system (the money market mutual funds) which,
to my untrained eye, looks very vulnerable indeed to
bank runs (or something similar enough to bank runs
that I'm not going to quibble).

When we discussed the question of whether MMMFs were
money, I think we concluded that the Fed could control
this part of the money supply
_under_normal_conditions_, because it controls the
interest rate. But I'm not sure how one would go
about bailing it out, or how one would prevent this
part of the money supply from more or less evaporating
in crunch conditions.

dd"

[dsquared]

[And the Fed doesn’t have any clear way to deal with bank runs on institutions that aren’t called banks...]

Course it does. This is all in Bagehot. The discount houses weren't called banks either. The discounting of short term bills is not exactly a brand new financial innovation, is it, and nor is the phenomenon of occasional difficulties in rolling over short term paper.

The central bank should lend

a) without limit
b) against good collateral
c) at a penal rate.

by the way, I think I will lodge a claim on this particular gold mine:

http://mailman.lbo-talk.org/2001/2001-March/004695.html

[Ginger Yellow]

"The difference between banks that are called banks and all other companies (including those producing {actually intermediating between consumers and producers of} real goods and services) is that investors in bank "products" expect with reasonable certainty to get back their investment and some interest. Those who invest in all other investment vehicles have no such expectation. They have accepted the risk."

Eh? Their investments are generally given the highest possible rating. They are secured on (for the most part) highly rated assets. There is asset specific and programme wide credit enhancement. There is full liquidity support from one or more highly rated banks. In what way would investors not have an expectation of being repaid principal and interest? Besides, apart from the case of extendible CP, all ABCP investors have been repaid so far, and even the extendible CP investors will likely get their money back eventually. In the meantime they're earning considerably more interest than they were before (admittedly not what a market rate would be at the moment).

[richard]

the grim reality continues to be the growing awareness........the music has stopped and there aren't enough chairs for all the dancers.

nothing the central banks can do will re start the music and allow the dancers to 'pretend' all is well.

the only question yet to answer is simple. do we have a depression and credit collapse or will and if so are they (the central banks) capable of......preventing said collapse? indeed if the central forestall a credit collapse it will mostly be at the expense of their respective paper currencies exchange rates to each other and most certainly to gold!

[richard]

the grim reality continues to be the growing awareness........the music has stopped and there aren't enough chairs for all the dancers.

nothing the central banks can do will re start the music and allow the dancers to 'pretend' all is well.

the only question yet to answer is simple. do we have a depression and credit collapse or will and if so are they (the central banks) capable of......preventing said collapse? indeed if the central forestall a credit collapse it will mostly be at the expense of their respective paper currencies exchange rates to each other and most certainly to gold!

[vtcodger]

A couple of questions from a non-economist if I may.

"Non-bank bank run" is a nice evocative phrase, but is it entirely accurate? I thought that a large element of this crisis is that there is a lot of paper in the financial system whose value is suspect; whose value can not be evaluated because of its complexity; and is not being traded because no one is willing to guess what it is actually worth. Sounds more similar to a currency crisis than a bank run?

Several other posts seem to say that that there is nothing much that central banks can do to mediate this particular financial debacle? Is that true?

Assuming that it is desirable to try to fix things and that the problem really is the effective illiquidity of complex derivative securities, are the proper steps not for someone -- perhaps the government or with a government push -- to establish a market in this paper (surely, much of it has some value?) then let things settle out?

While I'm all for helping out homeowners who have any reasonable hope of holding on to their homes, is it realistically possible to resolve this mess by tinkering with the US mortgage markets?

[vtcodger]

A couple of questions from a non-economist if I may.

"Non-bank bank run" is a nice evocative phrase, but is it entirely accurate? I thought that a large element of this crisis is that there is a lot of paper in the financial system whose value is suspect; whose value can not be evaluated because of its complexity; and is not being traded because no one is willing to guess what it is actually worth. Sounds more similar to a currency crisis than a bank run?

Several other posts seem to say that that there is nothing much that central banks can do to mediate this particular financial debacle? Is that true?

Assuming that it is desirable to try to fix things and that the problem really is the effective illiquidity of complex derivative securities, are the proper steps not for someone -- perhaps the government or with a government push -- to establish a market in this paper (surely, much of it has some value?) then let things settle out?

While I'm all for helping out homeowners who have any reasonable hope of holding on to their homes, is it realistically possible to resolve this mess by tinkering with the US mortgage markets?

[vtcodger]

A couple of questions from a non-economist if I may.

"Non-bank bank run" is a nice evocative phrase, but is it entirely accurate? I thought that a large element of this crisis is that there is a lot of paper in the financial system whose value is suspect; whose value can not be evaluated because of its complexity; and is not being traded because no one is willing to guess what it is actually worth. Sounds more similar to a currency crisis than a bank run?

Several other posts seem to say that that there is nothing much that central banks can do to mediate this particular financial debacle? Is that true?

Assuming that it is desirable to try to fix things and that the problem really is the effective illiquidity of complex derivative securities, are the proper steps not for someone -- perhaps the government or with a government push -- to establish a market in this paper (surely, much of it has some value?) then let things settle out?

While I'm all for helping out homeowners who have any reasonable hope of holding on to their homes, is it realistically possible to resolve this mess by tinkering with the US mortgage markets?

[don majors]

The current focus on mortgage financing diverts attention from unsecured credit card debt. This involves more of the populace -- perhaps at a lesser capital risk. How best to get a notion if it is a problem area? Its relative magnitude?

[Ginger Yellow]

Depends what you mean by "problem area". Problem for whom? The rating agencies regularly put out reports on the state of credit card securitisations - delinquencies, charge-offs, payment rates etc. That would be a good place to start. The UK credit card industry ran into serious trouble about two years ago, but things seem to have stabilised, albeit nowhere near the profitability/creditworthiness of a few years back. I haven't seen statistics on the US industry.

I think the reason people focus on mortgages is that a) so much of the economic recovery of the last five years has been down to the housing market, and b) traditionally people don't default on their home unless they absolutely have to, making it a better indicator of serious problems than unsecured debt.

[don majors]

G.19
CONSUMER CREDIT For release at 3 p.m. (Eastern Time)
August 7, 2007

Consumer credit increased at an annual rate of 5-1/2 percent in the second quarter of 2007. In June, consumer credit increased at an annual rate of 6-1/2 percent.

A lot of the consumer debt has been "securitized", bundled and sold off. If the rate of consumer loans exceeds cost of living; and adding the total indebtedness as ascribed to every man, woman and child in excess of $7,000 -- then this would seem to exceed mortgage indebtedness. Lowering the interest rates will encourage spending. The problem is that "workout options" will be constrained. Hopefully a mild recession will have to be endured until housing prices, dividend yields and payouts, executive compensation and tax strategies are revised to a reasonable balance. The following link is for the current FRB monthly report

LINK: http://www.federalreserve.gov/releases/g19/current/default.htm

[George J. Georganas]

Ginger Yellow,
"Eh? Their investments are generally given the highest possible rating. They are secured on (for the most part) highly rated assets. There is asset specific and programme wide credit enhancement. There is full liquidity support from one or more highly rated banks."
So the fault is with the rating agencies, much as it was with auditors in the previous crisis. Regulating the rating agencies can be no more than second-guessing their already hedged opinions.
"In what way would investors not have an expectation of being repaid principal and interest? Besides, apart from the case of extendible CP, all ABCP investors have been repaid so far, and even the extendible CP investors will likely get their money back eventually. In the meantime they're earning considerably more interest than they were before (admittedly not what a market rate would be at the moment)."
Fine but all this does not amount to deposit insurance. It all goes back to choosing whether one wants to eat plentifully or sleep in peace.

[Ginger Yellow]

"So the fault is with the rating agencies..."

I'm not saying the rating agencies are without fault here, but I'm not sure what you're trying to argue. Investors are being repaid. Their investments have held up in what is the worst possible market environement for these vehicles. If you were to pin it on any one thing, the fault would lie with investors and their advisers who decided that any AAA asset is the same as any other (or cash), and who assumed their extendible CP would never be extended.

The question for regulation is more to do with allowing banks to build up huge liquidity exposures to individual conduits, by the dodge of using different asset purchasing vehicles inside the conduits. Credit wise the risk in the vehicles is different, if correlated, but the risk to liquidity is to the conduit as a whole.