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Brian Richardson, CEO of mobile banking company Wizzit doesn’t understand the monetary policy, or so it seems.

He claims there is approximately R12bn of money outside of the formal banking system, or “under mattresses” as I believe he put it. This may be true.

Then, and this is where I have a problem, states that “It would have a massive impact if that money came into the market” with the implication that this would be a good thing. This reflects a broken understanding of monetary policy.

Putting this un-banked money into banks would allow it to be re-loaned, applying the multiplier effect and effectively expanding the money supply. Whether expansion of the money supply by R120bn (assuming effective multiplier is around 10) is a good thing or not is a question of fact, yet to be resolved.

Of course, if this were a good thing, the Reserve Bank could achieve the same thing through a combination of open market purchases of bonds (released cash into the money supply), weakening reserve requirements (allow the same money to be relent more times) or printing bank notes and dropping them from helicopters. They haven’t yet done this.

So it’s not really a good thing for the economy as a whole. It is a compelling argument for mobile banking though. Just saying.

It’s clear some people just don’t get that deflation is catastrophic from an economic perspective. You would have though that Japan’s lost decade (is it still only a decade?) would be sufficient warning.

Michael Pento from Euro Pacific capital writes about the options open Bernanke to stimulate the US economy through open market purchases given that interest rates are up against the zero bound.

He’s right about the options, but horribly misguided when it comes to wishing for deflation:

By keeping prices from falling more that they would have naturally, Fed intervention has created a burden.

The US public (and private) debt is such a significant portion of GDP, the correct answer cannot be to increase it as a percentage of GDP by deflating prices and keeping the nominal value of outstanding debt the same. Moreover, what the US needs is economic activity; encouraging everyone to leave their money in the bank because it increase in value every day and “nobody else is spending so deflation will continue” doesn’t sound like a success story to me. Downward price stickiness, particularly with wages (yes, even in the US) would add to the catastrophe.

Pent also raises the risk of hyperinflation:

…investors would be forced to once again abandon savings and chase runaway prices.

I don’t know how we went from fears of deflation to “runaway prices”. The challenge with this policy is to credibly promise moderate inflation for several years (depending on how strong your Ricardian views are).

Runaway prices are much easier to control than deflation. With inflation, we actually have a range of tools to use.

It’s unreal how many people have views on the economy that aren’t rooted in any economic theory at all.

From Stats SA

The headline inflation rate in July 2010 (i.e. the Consumer Price Index for all urban areas in July 2010 compared with that at July 2009) was 3,7%

The official inflation rate (i.e. the percentage change in the CPI for all urban areas in July 2010 compared with that in July 2009) was 3,7% at July 2010. This rate was 0,5 of a percentage point lower than the corresponding annual rate of 4,2% in June 2010 (i.e. the Consumer Price Index for all urban areas in June 2010 compared with that in June 2009).

From June 2010 to July 2010 the Consumer Price Index for all urban increased by 0,6%

CPI Headline July 2010 = 3,7%

So this is close to the bottom of our 3% to 6% inflation targeting range. Economic growth is struggling, unemployment is high, but we haven’t reduced interest rates? Something here is a little odd.

I’ll put another $100 in Kiva, to be “microlent” to businesses and people across the world, if the next monetary policy committee meeting doesn’t cut interest rates.

The FT has an article (Banks win battle to tone down Basel III) describing how the proposed new rules for banking capital requirements might have some of the new requirements around liquidity removed or weakened.

Key amongst these new considerations is the limitation of mismatches between the term of assets and liabilities, which would limit the danger of a removal of deposits and wholesale funding in a crisis scenario. The problem is that this has been fundamental to the business model of banks for decades. Short-term assets (call, overnight, 30 day deposits) have been used to finance long-term liabilities (vehicle loans, home loans, business loans).

Retail deposits, even those technically call deposits, are generally quite sticky. This is in spite of the easily recallable image of queues of depositors wanting to get their money back. Typically, this is still a small fraction of total depositors (certainly in countries with retail deposit protection). Further, other banks have usually pulled or tried to pull their short-term funding (or simply not renewed overnight lending) well before the public even gets wind that there might be risks. As banks rely increasingly on wholesale finance, the risks of a liquidity and credit crisis are amplified as this money is teflon-coated and greased in terms of stickiness.

The banks argue there are other ways of managing the risk. It’s understandable that regulators around the world have had their confidence in banks’ risk management ability dented.

The real danger of overregulation of banks is not “too safe banks”, but rather an increase in the cost of providing banking and credit services to the economy (individual countries as well as the global economy) which could make limit economic growth and the replacement of jobs lost during the recession.

It’s going to be interesting to see how this develops.

May 6 2010.  Dow falls more than 1,000 points intraday, including a drop of P&G from around $60 to (according to some accounts) below $40. The Dow recovered most of the falls quickly, but these trades are now part of the historical time series.

Banks and others using risk management tools often back-test their models against historical data to see how whether the models capture past market movements in estimating potential future market movements. This blip may appear as an anomaly in these tests for some time.

(It’s more typical for the tests to use only closing prices rather than intra-day prices. However, this actually reflects a weakness in the typical models and is only a fortunate escape from today’s problems)

The safety rules and rigorous enforcement of these regulations damages the profitability of the entire industry – just not in the way you might think.

Regulations and Big Bank Buildings

Why have banks historically had impressive  marble-slathered floors and columns, high ceilings and ornate, heavy front doors? Would you really deposit your salary and savings into an operation run out of a caravan parked on a corner on your way to work?

The fixed, permanent high-investment nature of the impressive buildings is one way that banks can  communicate their seriousness, their high investment requiring a long-term relationship with a large customer base to recoup their upfront costs and their inability to up and off and disappear with all their assets overnight. This communication of financial strength and longevity gives customers the confidence to trust in them and bank with them.

If you’ve thought about this for more than a few seconds, you should be asking an important question. “How do Internet-only banks, with their apparent lack of real, physical assets and high upfront investment in their operations support this argument?” (more…)

A friend “volunteered” me to answer an insurance question from Aardvark on allocating economic capital across different insurance products. After writing a short response, I received the frighteningly useful message: “Error”.

Having written a brief summary of the different techniques used in this really important area, I thought I should use it as a blog post. Maybe “Daan d.” from Cape Town will stumble across this answer eventually.

The question:

What is the standard practice to allow for diversification benefits when allocating capital required between different insurance products?

My brief answer (this is a huge topic!):

There is no standard practice. It’s one of the more irritating and subjective aspects of allocating capital between imperfectly correlated product

Economic Capital doesn’t have to be calculated as VaR, but I will use VaR below as a generalisation. Banks are typically slightly more mature in their capital allocation processes so what I’m describing below is often used in the banking world, but applies equally to insurance (life and non-life / P&C).

Splitting the capital in proportion to the sum of the components is frequently used, but is flawed and usually doesn’t give good results unless speed and simplicity are primary objectives. (more…)

The US Federal Deposit Insurance Corporation closed the 69th bank of 2009 recently. The rate of closures has increased recently, leading some analysts to believe that well over 100 banks could be closed this year.

The Savings and Loan crisis of the 1980s in the US started at about the same pace, with 100 closures per year. However, the number of closures increased to a peak of 534 in 1989 – fully 9 years after the start of the uptick in closures in 1980.

The South African banking environment is different – very much fewer banks and arguably tighter regulation give the lack of deposit insurance. However, the pain that US banks are feeling informs views that our banking sector still has pain to live through before turning around.