I’ve been seeing a lot of the following around the place:

Looks pretty scary right – red columns go lower than during the Global Financial Crisis :O

However, these big red columns are a bit misleading. The data is true – financial institutions holding government bonds have made large unrealised losses on government bonds due to the surge in interest rates. But there is a reason that financial regulations don’t make banks recognise these losses.

Now I don’t know much about much, so I’ll talk through some of the basics of how these things fit together and how I understand it. When there is something important I’ve missed feel free to point it out – but I think after the discussion we’ll at least be in a less misleading place than “giant red bar on Twitter”.

tl;dr: Unrealised losses on government bonds for banks are not really a concern. The real concern would be if there was a genuine increase in bad debt/default. However, the existence of these unrealised losses may make financial markets more sensitive to shocks.

A stylised bond

Imagine a world where you are deciding what to do with a spare $100 you have sitting in your pocket – and you’ve made a decision you want to save it to spend in a year.

In this make pretend world you have four options:

1. Change your mind and spend it – if the product is durable you could sell it in the future.
2. Hold the cash.
3. Pop the cash in a bank and earn interest.
4. Purchase a fixed-income instrument that matures in a year – i.e. a government bond.

To keep things simple, lets focus on your choice among the last two – say because the things you can buy are really expensive to store or resell, and cash is expected to fall in value through time due to inflation.

If I pop the money in the bank, then a year later I get it back with interest. Lets assume an interest rate of 5%, that means that in 1 year I have $105. Nice.

Now say that there is a bond sitting there that is completely riskless. It costs $100, pays me a $5 coupon during the year, and at maturity will pay me $100 (the face value). Well buying this bond involves saving $100 now and receiving $105 in the future – so it looks like the same thing, with a 5% interest rate.

If interest rates suddenly doubled the equation changes. The doubling in interest rates mean that, if I put the money in the bank I will end up with $110. However, in the bond example I have $105. As a result, I’m not buying the bond – I’m going to save the money.

In fact, a lot of other people will do the same thing – reducing demand for bonds. People will be willing to sell the bond until the yield on the bond (amount received in a year divided by the amount paid now) is the same as the interest rate. As the coupon payment is a fixed amount of income the price of the bond must adjust.

This implies that the price of the bond must decline to around $95.45 (since this amount plus 10% is approximately the $105 received in a year).

Now assume that the interest rate occurred after I had purchased the bond. In this case I am holding a bond that I paid $100 for, but the price has fallen by 4.5%!

In one sense I have lost money – if I went and sold the bond right now to consume right now, I would have less than the $100 I started with.

In another sense, nothing has happened – if I was always going to wait to maturity I am going to end up with $105 in the future, just like I was anticipating before the interest rate change. In this way I haven’t lost anything and my financial situation is purely unchanged.

If bank are just holding these bonds to maturity – in the way they are with other loans – then these losses don’t effect anything, they are just paper losses. However, if they intended to buy and sell the bonds as a means of liquidity management in the here and now this wouldn’t be so good.

Is this a concern?

According to people on twitter the sharp drop in the market value of bonds is a concern. Why? Big red line mate – time to load up specifically on my crytpocurrency.

To be more specific, the inference is that this unrealised loss is still a loss – just like individuals defaulting on loans, this should be seen as a reduction in the value of assets of the firm.

A reduction in the value of assets implies that – at a point in time – a bank will have less available to meet its liabilities (i.e. our deposits at a bank). This could play out in a couple of ways:

1. Since assets = liabilities + equity a sharp drop in the value of assets may make the net equity in the bank negative – making it insolvent!
2. Even without insolvency, if concerns about these unrealised losses led an increasing number of individuals to withdraw this would run down banks liquid reserves, and increase the chance they have to sell bonds and realise the loss – leading to a self-fufilling bank run.

The first case is a pretty much non-issue. As noted above, if the bond is held to maturity an unrealised gain or loss is just a “paper” change in value – it does not change the real financial situation of the bank.

The issue only occurs if the bank is forced to realise this loss.

So say there is a sharp increase in demand for funds from depositors, how does this play out.

• Seeing that there is an increasing demand for funds, retail banks need to meet this.
• If inter-bank lending is also limited (due to other banks feeling similar pressure) the bank will feel tempted to use their bonds to gain access to liquid funds to meet this demand from depositors.
• They can do this by borrowing from the central bank, using the government bonds they hold as collateral.

Recently an RBA assistant governor even gave a speech about how all of this works – give it a look!

Summing everything up – these unrealised losses on government bonds for banks that are the topic of twitter are not really a concern. The real concern would be if there was a genuine increase in bad debt/default.

However, in a world of uncertainty where there are certain triggers for default (rising unemployment, structural reform in China and their housing bubble) the concern about unrealised losses can make financial markets a bit more fragile to these shocks – something that financial regulators will be keeping an eye on.

If they have large amount of cash in the bank, the answer is likely to be yes. Yet most firms don’t have a large amount of cash in the bank. Rather, they have large amounts of productive assets – sometimes physical assets like machinery and equipment, and sometimes intangible assets like good business routines, long standing customers, or patented technologies. These assets will produce them with cash incomes in the future – but only if they can survive until then. 

So how can we think about this issue?

The best analysis of this problem has been laid out by two Nobel prize winning economists, Jean Tirole and Bengt Holmström.

In a series of papers begun in the 1990s, they analysed how firms make investment decisions and structure their balance sheets in response to the possibility of liquidity crises that are unrelated to the fundamental performance of their business.

The basic answer is that firms become conservative, and clearly distinguish between fundamental risk and liquidity risk. When contemplating a business proposal, firms evaluate how much money their investment is likely to make in the future – its fundamental risk. They also evaluate how an investment may change their balance sheet and expose them to liquidity risk – the prospect they may go bankrupt during a liquidity crisis unrelated to the investment they are making.

Bankruptcy or closure is a threat if banks change their normal lending practices in response to a crisis, because firms that have spent their cash reserves or undertaken significant borrowing to finance their investments may be unable to pay their bills. As a result, firms overlook a lot of potentially profitable investments, not because they don’t think they will be profitable but because they increase the chance of going bankrupt if something else goes wrong in the economy.

A bloody parable may be in order. Suppose you had an accident in a car. The fundamental risk is that you suffer long term bodily damage  – perhaps you lose an arm. The liquidity risk is that you bleed to death before an ambulance comes, even though you would survive and perhaps fully recover if the ambulance arrives in time and stops the bleeding. If you are concerned that an ambulance may not be available in time, you might avoid trips that would have been very enjoyable simply because the risk of dying from an accident that is usually treatable is too high. 

We are in the equivalent of one of these situations now. A lot of firms are at risk of bankruptcy not because they don’t have sound business plans and valuable assets but because the usual loans they might expect from banks are not available or may not be available. Perhaps these firms should have secured guaranteed finance (lines of credit) in the event of a crisis – a type of insurance – as many firms have done. But if they haven’t, the economy risks a lot of fundamentally sound firms becoming bankrupt or significantly smaller because a bank is unwilling or unable to provide a temporary loan to help them deal with a temporary shock. If these firm fatalities lead to the loss of a lot of intangible assets, the medium term damage to the economy can be considerable.

Liquidity risk outside of a crisis

I can’t claim any expertise as to what the government, its agent the Reserve Bank of New Zealand, or private banks should be doing during the crisis. As a result, this is an issue that will be litigated elsewhere.

I am more interested in how the Government should respond to the problem of liquidity crises when they are not in a crisis. Obviously it is a good idea to have thought about what to do in advance! But a different implication is to consider how the government evaluates its own investments and its own balance sheets.

Governments are much less susceptible to liquidity crises then most private sector firms, because they can borrow during a crisis as they are indefinitely lived and people are convinced they will exist and repay their loans once the crisis is over. Countries, unlike firms, don’t often disappear  – and nor do their tax paying citizens. In fact, the margin between Government borrowing rates and private sector borrowing rates typically increases during a crisis, as Fama and French established over thirty years ago. This is one reason why central banks can act as a lender of last resort when private banking crises occur. 

The comparative advantage governments have at managing liquidity means the government should contemplate its own investment strategies differently than the private sector. It faces different fundamental and liquidity risk than private sector firms. This is not a radical idea because very large private sector firms act differently than small private sector firms since they have different liquidity risk profiles as well.

This is one of the reasons that most governments – but not New Zealand – use a discount rate to evaluate their investments that is much lower than the “hurdle” rate used by private sector firms. 

Contemplating hurdle rates

This is one of the interesting question facing governments in non-crisis times: what is a reasonable rate of return on government investments?

For years the New Zealand government has argued that it should be the same as the rate of return on private sector investments, and has used this argument to justify one of the highest public discount rates in the OECD.

Yet this is not necessarily the case if the government faces a different combination of liquidity risk and fundamental risk than the private sector. If the public prefers to hold safe government debt rather than risky private sector assets it is perfectly sensible for the government to issue government debt at 2% and invest in projects that return 5 % even if the private sector will not make investments unless the expected return is 10 percent.

To push my analogy to extremes, some people may prefer to travel in a slow government car with guaranteed access to emergency medical services than travel in a fast private sector car with the same risk of an accident but a higher possibility of bleeding to death.

Does the difference between fundamental and liquidity risk matter? Yes, if a very high government discount rate is one of the reasons why New Zealand has underinvested in government-provided  infrastructure. Yes, if a very high government discount rate means New Zealand avoids making investments in high yielding long-term projects because the long term return is discounted at too high a rate. 

Even if the Government has a comparative advantage at liquidity risk, this does not mean it has a comparative advantage at fundamental risk.

In fact few if any economists believe that governments are better at evaluating fundamental business opportunities than the private sector, because the incentives that politicians and civil servants face are quite different than those sharpening the minds of private investors. This is one of the reasons why western governments usually try to separate government and private sector investments domains, so each can do what each is best at.

Nonetheless, the government should take advantage of its comparative advantage at liquidity management in the sectors in which it can invest, and if this means reducing the government discount rate to a level similar to the more successful OECD economies in the rest of the world, so be it.

Note: this post is based on a paper written for the NZ Treasury in 2016 “Liquidity, the government balance sheet, and the public sector discount rate.” The paper is available on request.

References

Fama, Eugene F. and Kenneth R. French (1989) “ Business conditions and expected returns on stocks and bonds,” Journal of Financial Economics 25 23-49.

Holmström, Bengt and Jean Tirole (1998) “ Private and Public supply of Liquidity”, Journal of Political Economy 106(1) 1 – 40.

Holmström, Bengt and Jean Tirole (2000) “Liquidity and risk management,” Journal of Money, Credit and Banking 32(3 pt1) 295-319.

Holmström, Bengt and Jean Tirole (2001) “ A liquidity-based asset pricing model,” Journal of Finance 56(5) 1837-1867.

Holmström, Bengt and Jean Tirole (2011) Inside and outside liquidity (Cambridge, Ma: MIT Press). 

Now Piketty expressly discusses capital gains in his book – and he points out that he does not view the current increase in the value of capital as a bubble, instead it is the value of capital returning to its “real” level.  In that way, he views the idea of saying that we have a bubble as both wrong and beside the point.

Say that we accept the implied assumption he works with – that there isn’t (and hasn’t been) a bubble in housing markets.  Given this, it is important at this point to consider the narrative he has for history.  He discusses a period (pre-WWI) where governments offered a high risk free rate of return, where wealth was (in some ways) heavily insured by government, and where (as a result) the value of capital was high and the private risk premium was low [best example of this was his discussion of the UK, where government debt offered a high risk free yield for those who could invest in it].  WWI and WWII – with the combination of war and the change in government policies (towards appropriation and direct regulation) changed this – the private risk premium was now a lot higher, and the value of capital dropped as a result.  Government protection and regulation is BUILT INTO the price of an asset!

In Piketty’s data we are looking at a situation where government policies have changed, and as a result so has the inherent private risk premium associated with assets, pushing up the price of assets.  This description suggests that, if there is a failure, it is due to an “implicit subsidy” by governments to capital owners – it is in essence the same policy failure that those in financial/macroeconomics have been discussing for years now (a quick look on the blog for recent posts gives these 1,2,3,4 – more importantly don’t forget this and suggestions by Cochrane to make the financial system run free and remove this implicit subsidy).

If this is the real cause of the changing capital to output ratios, then it suggests economists have already been investigating the key cause – and that there is no natural tendency for capitalism to head this way.  Even if we don’t deal with the inherent injustice, capital/output ratios shouldn’t intensify.  And furthermore, this would suggest that there is no need for a capital tax to deal with the perceived injustice – instead we just need to remove an implicit subsidy, and it make investigation into financial regulation even higher on the research agenda!

This is an incredibly important issue to investigate with respect to Piketty’s central thesis – his data set is incredible, but there is a lot of work to be done teasing out what it actually means, let alone defining what correct policy is.  Even while I was reading this book, I could not get this alternative hypothesis out of my head – and Tabarrok’s post has just increased my belief that this alternative hypothesis is the correct one.

Still, don’t read me.  Read Cochrane (here, here, here, here, here).  And Marginal Revolution (here, here, here, here, here, here).

Also I enjoyed this.  And this post on why the Chicago school gets so many Nobel laureates is a good counter-measure to all the arbitrary bile that can be thrown around on the interwebs .  I also enjoyed this post from Noah Smith.

I have a bias towards Shiller in all of this because of my interests.  He is a big proponent of trying to view economic phenomenon through a lens of history dependence (with the regulatory difficulties that entails) and has talked about how exciting neuroeconomics is – completely agree.  However, this has nothing to do with empirical finance in of itself, as this is not my field.  While I think some of the stuff is pretty cool (and remember really like GMM a few years back) I have nothing to say.  Hence why you should be going back and clicking those links to Cochrane and Marginal Revolution

Not so long ago I wanted to note how to think about the causes of why we may move towards LVRs (maximum loan-to-value ratios on mortgage lending) in New Zealand.  I noted the following in terms of some quotes they had made:

Either these quotes miscommunicate the justification the Bank is using for such policies, I have completely misinterpreted the quotes, or they communicate it perfectly and I fundamentally disagree with the association they are using.

It is now clear that the RBNZ’s communication is crystal clear, and I fundamentally disagree with an element of their justification for LVRs.

Now I don’t come from this point of view because I am anti-RBNZ.  The RBNZ is one of the most transparent, effective, and dynamic central banks in the world.  RBNZ actions helped to prevent the full brunt of the financial crisis smashing into New Zealand – acting far more rapidly than I had recognised was necessary at the time.  RBNZ actions have ensured that our financial system is relatively secure.  RBNZ research is both incredibly good, and made to be very accessible.  Furthermore, their willingness to accept their role at regulator and to be conscious of regulation and risks given that relationship is both admirable and appropriate.

But to pretend I agreed about the way LVRs are being sold out in public would be a lie – as my boss said to me yesterday after reading my post it sounded like I was “sucking up to the Bank” given his knowledge of my views.

The “why” of macroprudential policy

Although the Bank seems unusually unclear on this point, they appear to be saying that they are unwilling to lift interest rates because the increase in house prices is not due to a generalised increase in demand – instead “for some reason” the relative price of housing is climbing.  Given the replacement cost of housing, the yield on housing, and income growth, the level house prices are rising too relative to other goods and services is high.

This is how I have to interpret what the Bank is saying – as it the lift in house price is due to a lift in general demand, they should simply be increasing interest rates.

Now given this the Bank notes the following:

Rapidly increasing house prices increase the likelihood and the potential impact of a significant fall in house prices at some point in the future

To which I have said, and will continue saying, who gives two hoots!

This isn’t to say we shouldn’t give two hoots – but just that we need to actually justify why hoots are given before reacting to this!

As we’ve noted in the past we need to think about the market failure involved.  In this way, we need to think about the inherent ‘externality’ that is involved.

Now the RBNZ has a point when they say:

“The Reserve Bank considers that LVR speed limits will be more effective than other macro-prudential tools in constraining private sector credit growth in the housing sector, and dampening housing demand. Other macro-prudential instruments, such as counter-cyclical capital buffers and capital overlays on sectoral capital requirements, are likely to have less effect on the demand for housing-related credit and on house price growth.”

Given that, during an “upswing” in the cycle, higher asset prices make it easier for banks to claim they have sufficient capital.  In this context, LVRs and the such are often justified as more direct.

But I also think this misses the point of what we are trying to achieve with macroprudential regulation.  We are fundamentally concerned about the stability of the banking system for two overarching reasons:

1. The fact the banking system is implicitly backstopped by government.
2. The idea that although banks take into account risk, they ignore systemic risks.  Furthermore, these risks can be exacerbated and changed through time by “complementary” behaviour – herd behaviour and irrational bubbles in this sense.

In this context LVRs are a bit unusual.  In this case, it should NOT up to the RBNZ to decide the “quality” of the lenders banks should be choosing – instead under their financial stability guise they are aiming to ensure that these heavily regulated and protected banks are holding sufficient capital to deal with the risk associated with a sharp drop in house prices.  Aiming our regulatory guns at borrowers misses the point, and is a poorly targeted way of trying to solve a macro-prudential concern stemming from asset price risk in a specific sector.

However, that was not my area of real disagreement – as I have previously accepted that LVRs are a “stop gap” measure as more appropriate schemes are designed in the background.  Stating that the concern is “house prices” is something I fundamentally disagree with.

Even if we ignore the points on communication I touch on later on there is something more fundamental.  The concern is not the asset prices, it is not a bubble, it is financial stability.  The RBNZ’s role it NOT to prevent people hurting themselves (transfers associated with volatility in house prices), it is to prevent their actions hurting other people (the financial instability due to banks holding insufficient capital given the risk of a systemic event)!!  I would note that I describe this more clearly in the earlier post here.

But how are we supposed to articulate risk without talking about house prices!

O.o … what

Discuss banks and borrowers taking on excessive leverage, and by all means roll out:

Rapidly increasing house prices increase the likelihood and the potential impact of a significant fall in house prices at some point in the future

But then state that the purpose of the policy is to ensure that banks are taking “risks into account appropriately” and that the RBNZ can’t control prices.  The Bank is completely and totally right that large increases in prices make declines more likely and that there is risk here – but the purpose of the policy IS NOT to bring house prices down or slow growth, it is just to ensure the stability of the financial system.

Never forget that if we are really responding to some “irrational bubble” it is unlikely policy can do anything to assuage it – instead appropriate policy (in my view) will try to protect the broader economy from a situation where the “bubble pops” and there is a transfer of resources between owners and non-owners, by making sure the financial system is appropriately regulated/taking into account these risks.

By explicitly stating that they are aiming to slow growth in house prices, and by not explicitly stating that it isn’t house prices that matter but the fact that banks are appropriately taking into account risk, the Bank is inherently saying something very different.  They are essentially stating that they have a concern about this transfer, and they are in part taking on a roll that belongs to government and private choice – not central bank management.

Wealth effects and stuff!

O.o who is writing these titles!

If the concern is wealth effects and not financial stability … then we are talking about rising domestic demand stemming from higher asset prices, and thereby higher future inflation.  Use monetary policy.  If our concern is that the house prices will rise then flash fall, we are again talking about an issue we should look past – it is not up to the Bank to “fine tune” the economy.

Also, be careful using “wealth effects” from housing.  Current evidence suggests that the wealth effect from housing is largely not a “traditional” one but is in fact due to a loosening in credit constraints for younger households (recent work here and here).  In this way, the volatility in consumption may be welfare improving – the actual impact of a rise and fall in house prices on welfare is ambiguous!

Confusing people on affordability

I was concerned when the RBNZ mentioned housing affordability in the past, given that this is 100% not their mandate.  I was as a result encouraged it did not turn up in this speech!

But I’m not sure what the RBNZ expects people to take from them constantly stating that its policy choices will bring down house prices.  What they should expect is a group of people in the public who now think the RBNZ in some way “controls house prices” and “controls housing affordability”.  You may well say that is not what the Bank meant, and I will be honest they were a lot more careful this time with their language – but this does not change the way some will interpret it!

Think about it a bit.  How would the man on the street interpret a central bank saying “house prices are too high” or “An important issue is how long LVR restrictions might be imposed. This largely depends on the effectiveness of the measures in restraining the growth in housing lending and house price inflation”.  I imagine a number of people hear from this that prices are wrong, and the RBNZ is going to fix em, good times!

Given the previous context of financial stability, there is no need to mention how house prices will change, or even state that a “relative price” is wrong.  The RBNZ’s role in terms of financial stability is to ensure that banking regulation is appropriate, as a form of insurance against the risk of failure, not to determine house and other asset prices.  Update:  Oww my …. constraining people is now in their own interest.  Superb, this is not inappropriate ad hoc ex-post justification at all.

Mixing your instruments

This statement was incredibly unnecessary:

In this way, LVR restrictions will support monetary policy. While the primary purpose of the restrictions is financial stability, they will also provide the Reserve Bank with more degrees of freedom in conducting monetary policy. In particular, they will provide the Bank with greater flexibility in considering the timing and magnitude of any future increases in the OCR.

If the Bank believes that tighter monetary conditions are appropriate … tighten monetary conditions.

Yes the dollar is high, what exactly do you expect when NZ is going through a MASSIVE non-tradable investment binge (the Canterbury rebuild).  The rebuild involves significant activity, and will crowd out other forms of activity, this is undeniable.  No amount of “cute” central bank fiddling will change anything about this.

If the purpose of LVRs is to try to deal with concerns about systemic risk in the banking system … then make that case and don’t talk about monetary policy.  Yes the two are intertwined, just like fiscal and monetary policy are intertwined – but you still talk about them with reference to their actual targets.

Why say that we can avoid “trade-offs” by mixing together policies – as that is what is sounds like here.  In truth, all the Reserve Bank is doing is changing the trade-off, and they are doing it by explicitly shutting a bunch of people out of credit markets.  It will only have much of an impact in terms of monetary policy and the such if the LVR restrictions are incredibly good at keeping first home buyers out of the housing market … an interesting choice by our currently politically independent central bank.

Aren’t you splitting hairs – what is the difference between what the Bank’s said and what you are trying to say?

I see where you are coming from.  I can see an area of justification for LVR policy, I admit that macroprudential policy can have a role, I see increasing leverage and high house prices as offering an sector specific area for systemic risk.

But the difference between explicitly stating that changing house prices is a goal (RBNZ) and explicitly stating that changing house prices is a side product (me) is a fundamental difference in views.  My view is that it is not appropriate for a central bank to start further “managing” an economy by targeting a specific price outside of guiding broad macro variables (cash rate in relation to monetary conditions, inflation) and implementing specific regulation to internalise risk in the banking system.

The RBNZ made it clear that they are bringing in these regulations to lower house prices (note slowing growth is the same as fundamentally saying that you believe the policy will lower house price growth).  While lower price growth may be a result of policy, it should not be the aim, and that is where I’m strongly in disagreement.

I don’t see this as a small issue.  The decision about whether the goal is a price or whether it is to deal with some form of bank stability directly is core to the issue, the perception of success, the policies that seem appropriate, and the way these policies are communicated.  Hence why I view this difference as blog worthy

They noted that the run up in house prices has increased the probability of a sharp decline in house prices – an event that may in turn lead to instability in the New Zealand financial system.  Their thinking is:

“The LVR restrictions are designed to help slow the rate of housing-related credit growth and house price inflation, thereby reducing the risk of a substantial downward correction in house prices that would damage the financial sector and the broader economy.”

In this way it is pre-emptive – current credit growth is moderate, but they want to ensure they don’t lose control of credit growth in a way that makes the entire financial system (which is implicitly insured by government) fragile.

The Bank makes a specific point of saying that the concern is around mortgage borrowing, and a run up in house price expectations associated with already realised increases in house prices, that they are targeting with macro-prudential policy – as unlike an increase in the OCR which is targeted at broad demand, it is a specific lift in demand for housing that is driving current house price appreciation.  It is not that NZ households have become more willing to spend per se – the concern is that NZ households, and the banks willingness to lend to households, is focused excessively on housing assets.

I will admit that I am not completely sold on the argument they have put forward for LVRs, and I’m perplexed at why they are communicating it by discussing house prices (thereby mixing it with issues of affordability for the public) rather than simply stating that they are of the view that banks are taking on too much risk in terms of mortgage assets at present.

But they have clearly laid out their argument, and they have made sure that they communicate it rather than just doing it.  And this is great – I am alway impressed by how transparent our central bank is!  I think that this helps them when it comes to introducing specific, one-off, policies such as the current LVR limts.

The only point I have to add is that some may say “why charge poor old depositors”.  I’d note here that we need to think about the “incidence of tax” – if it is true that depositors have no market power, then the entire burden of the tax will fall on banks and borrowers.

This is all part of a broader debate on deposit guarantees (here, here) – if we rule them out, we rule out the justification for a levy as well.  I’d add there is a big issue I haven’t touched – what is our ability to limit deposit insurance given concerns about “bank stability”, and what do we do when banks are just too big (think Ireland and Iceland).  My real desire is to see transparent, and credible, ex-ante policy … and to be honest about the trade-offs we are facing and accepting.

Either way, my focused has switched back to methodology issues as I’ve realised I need to intensify work on my NZAE paper this year (posts here and here) … in case they actually decide to accept the abstract I’ve just submitted.  As a result, when I next get a chance to sit down there are two posts I want to write about assumptions, and then I might start blogging some of the background material I’ve already written about for the paper.

However, knowing me I’ll just start ranting about whatever I see in the paper instead

While the professionals used their decades of investment knowledge and traditional stock-picking methods, the cat selected stocks by throwing his favourite toy mouse on a grid of numbers allocated to different companies.

And the results? Orlando the cat unsurprisingly (to anyone who has studied finance and whose job isn’t giving investment advice) earned more money than the professionals.

At least the kids didn’t beat the pros, that would be embarrassing if they did….

…after an anomaly has been published, it quickly shrinks – although it does not disappear.

The anomalies are most likely to persist when they apply to small, illiquid markets – as one might expect, because there it is harder to profit from the anomaly.

It’s always good to remind ourselves that all anomalies are only fully priced in equilibrium, and we’re probably never in equilibrium. The process of moving towards equilibrium involves market participants seeking out those anomalies and exploiting them. So the continued discovery of new market anomalies isn’t evidence against market efficiency: it’s merely observation of the normal equilibrating process.

Taxpayers still face the risk of seeing bank losses socialised in future while today’s profits are privatised.

A more honest solution would be for the Government and the Reserve Bank to openly state that a bailout would not occur. Term depositers would demand a higher return to compensate for the higher risk, and it would remove the moral hazard that currently subsidises the profits of Australian banks.

Now lets be a bit careful here.  Yes there is an implicit government guarantee of banks – in fact the way to look at it is through the lens of a deposit guarantee, when it comes to the big banks the New Zealand government will not allow depositors to lose out.

The logic behind this is the fear of a bank run.  The reason we hadn’t had a financial crisis  on a global scale between the Great Depression and 2007 was largely due to the implicit deposit guarantees that soveriegn nations had put in place during the 1930s.  Even if these were not always “explicit” they helped prevent runs on the banking system, which engendered confidence and prevented financial crises.  One key reason for the GFC during 2007-2009 was the sudden change in behaviour by governments – where they were showing themselves suddenly unwilling to provide this insurance on the basis of “moral hazard”.  It is true that issues of moral hazard had helped to drive risky lending, but it was confusion around where the burden of debt fell and a lack of clarity around who was “implicitly insured by government” that led to a run on wholesale financial markets and the financial crisis.

The “solution” to any perceived issue in our banking system is not to get rid of deposit guarantees, and it is not to remove the implied subsidy that this may provide to the New Zealand banking system.  It is to ensure that banks in turn face this cost during the rest of the cycle.

The RBNZ’s desire to set up the OBR is based on a desire to prevent bank runs, while also making who bears the burden of a bank failure “fairer”.  They are trying to ensure that we don’t have a financial crisis, while minimising the cost associated with “moral hazard”.  This is preferable to forgeting the lessons of the Great Depression and GFC, which is what we would be doing if we were to completely pull away from the implicit back stop of the banking system.  Trust me, I don’t like implicit insurance for industries myself – but financial markets are one area where such things need to take place, and as Hickey says they have to take place in a transparent manner.