How to protect depositors without bailing out the bankers!

The above is Laiki’s(Cypriot bank to be bailed out) balance sheet, which I pulled off their latest annual statement. I highlighted the assets which are safe in yellow, the assets which are risky in green and the “other” in blue.

I then highlighted the liabilities which we are trying to protect, the deposits, in yellow, and the liabilities which we don’t in want to safeguard in green. I then added those up in 3 categories of assets and 2 categories of liabilities the result is the column on the left in the picture below.

I then give all the safe/liquid assets to the good bank along with an optimistic portion of long-term which will be paid back. It is likely the majority of these are loans to Greeks which are unsafe and will probably not be paid back in full, so I assumed an 80% repayment rate, which might be optimistic, but the approach also works with less optimistic repayment rates, the difference being the good bank’s capital ratio, the capital ratio and the repayment rate are positively correlated.

Assets

Essentially all of the liquid assets are given to the good bank and all the illiquid ones to the bad bank (in practice this would include some headquarters to continue with their remaining operations). The biggest asset for Laiki is the “advances to customers” this will have to undergo special evaluation for the split between liquid and illiquid to occur. The most important aspect here is that the bad bank holds the equity of the good bank, note that this means that the capital ratio for the bad bank remains fixed no matter how many assets are given to the good bank, nevertheless the good bank should have a maximum amount of liquid assets to ensure safety.

Liabilities

The only liability the good bank needs to take on is the customer deposits since it is what we are trying to protect and it is what prevents us from allowing them to declare bankruptcy. Once the deposits have been secured, capitalism can work again.

Equity

Both the old Laiki equity and the good bank Laiki equity are given to the bad bank.

What this achieves:

1)      The Deposits are safe and danger of a bank run is eliminated

2)      Remaining debt that was never promised a government guarantee goes to the bad bank.

3)      The old Laiki (bad bank) is still relatively better capitalized but still responsible for the decisions they made. If they do become insolvent they can declare bankruptcy without interfering with customers deposits, this means they can now be treated as a normal company.

4)      It’s important to highlight that this approach is not complementary(though it can be) to a bailout but a substitute, which does guarantee that bankers will not be over or under punished but will bear the fruits of their actions.

In practice

The good bank will continue to work under the Laiki brand and continue its operations just like normal whilst the bad bank will be running in the background trying to properly manage its existing assets. It will still benefit from profitable activity from the good bank but will be treated like a normal company. No public money (excluding any administrative costs to make this plan work) has been used and stability has been restored. Over time the good bank can also engage in secondary market trading and that can still follow the shareholder’s wishes and should the good bank face a similar crisis that Laiki is facing then the process can be renewed with a new good bank and the old good bank transformed into a new bad bank.

A pre-requisite for this approach to work is that there are sufficient safe assets, and a minor risk this mechanism faces is that banks will no longer favour liquid assets as to not allow this mechanism to work and force a bailout. This is however an extreme scenario that would not occur with properly executed regulation.

This innovative approach has been very well received academically but has not been applied anywhere yet.

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Price System: some assumptions

This randomly came up today and I got to thinking about when the price system is the best way to distribute things, I should mention that this is off the top of my head so it might not be a textbook complete answer. This is related to my other post about price gouging.

So the assumptions i’m going to talk about are going to be in order of ascending rarity: unequal utility; limited resources; limited wealth inequality; and rational people.

Unequal utility, this assumption is the easiest to meet, its hard to even think of a situation where utility is the same. This is because not everybody values things in the same way, even if its their life you are talking about, some people may be suicidal, whilst others might be willing to kill a hundred babies to live. The trick here is an element of perception of utility, one might perceive a higher or lower utility than the actual one he will get and that might distort things, but this is probably more relevant in the rational people section.

Limited resources, this is also fairly easy to assume, there’s never an infinite amount of resources. If you have an infinite amount of television sets available to people then they will maybe use the first 3 to watch 3 channels at once, maybe more if they handle more than that, then, the next couple will be for backup, then maybe you would like to use the next couple as chairs around the house, then the couple maybe for releasing stress by dropping them off the 7th floor. The point is that there is diminishing marginal utility from these televisions but since they are free you have no reason to stop getting them. Of course what matters is not whether or not the resource is infinite, but whether your access to it is infinite.

Limited wealth inequality is touched on in my last post but its also an important assumption. Relatively more money allows for relatively more leisure, if there is a heart for sale and someone only has 10 dollars and is willing to use it all to purchase this heard because his is about to expire. But someone else who is in fine shape whose heart is only 0.1% likely to fail him in the next decade but who has a trillion dollars, would maybe be willing to pay 1000 dollars to buy the heart and freeze it somewhere as insurance. Here excessive inequality has led to the item in question not being used to its highest utility.

I should mention that the wealth doesn’t have to be a liquid asset, even a house or future promises to achieve something, maybe even offering yourself up to be a sex slave, in this case even gender creates inequality, since if the vendor is a straight man, then females will have an extra option to exchange for the heart.

Rational people is in my mind the most far reaching assumption. This is because you might have people who use morals, religion, or have some other irrational mechanism with which they make decisions. There are many cases of people not adapting to their environment to offer up the service or product required to achieve their end means because of morals. You might be desperate for food and find someone selling a loaf of bread for 1000 dollars and think that he is ripping you off and so you decide to wait for someone cheaper to come along, without knowing if this cheaper vendor even exists.

Worse yet, even if there is perfect equality, and a given person x has a higher utility than everyone else and there is only a single unit of the product that will save him, and he knows that there is only one unit and only one chance to buy it(heck it could even be free), he might still decide to forego it due to religious reasons.

We must also assume rationality from the vendor’s side, although its perfectly rational to accept only cash if you don’t trust the people around you. If he does trust everyone to a good degree then he should be able to accept illiquid forms of cash as long as the time value of money is taken into account in the form of interest. It is also true that for the vendor to perfectly utilize the price system he must be able to analyze and calculate the perfect price for his product at any given time in order to make sure that he sells it at the highest price where it is going to be sold out. Even if you sell a bottle of water for 100 dollars, you would have been better off selling two for anything over 50, so its important to be able to price things as optimally as possible.

Should feminists be suffering from existentialism?

Usually I don’t like him because he takes every chance he gets to jump on the “hate government bandwagon” but lets start with Thomas Sowell’s recent column anyway. He tell us what Ceteris Parabis is:

“The old — and repeatedly discredited — game of citing women’s incomes as some percentage of men’s incomes is being played once again, as part of the “war on women” theme.

Since women average fewer hours of work per year, and fewer years of consecutive full-time employment than men, among other differences, comparisons of male and female annual earnings are comparisons of apples and oranges, as various female economists have pointed out.

When you compare women and men in the same occupations with the same skills, education, hours of work, and many other factors that go into determining pay, the differences in incomes shrink to the vanishing point — and, in some cases, the women earn more than comparable men.”

Then lets move to this first paper here:

In 2003, a new law required that 40% of Norwegian firms’ directors be women—at the time only 9% of directors were women. We use the prequota cross-sectional variation in female board representation to instrument for exogenous changes to corporate boards following the quota. We find that the constraint imposed by the quota caused a significant drop in the stock price at the announcement of the law and a large decline in Tobin’s Q over the following years, consistent with the idea that firms choose boards to maximize value. The quota led to younger and less experienced boards, increases in leverage and acquisitions, and deterioration in operating performance.

Now on the the Bureau of labor statistics. On average women work less hours than men, men work 40 and women work 35 hours per week. So that’s another explanation of the mythical “gender wage gap”, you could try to argue that the dependent variable in the model should just be the earnings per hour, but it would not work because its natural that people who work more hours get the promotion. This study here also supports the BLS:

In our data, the median male physician with 10 years of experience works 11 hours per week more than the median female physician in our sample with 10 years of experience. Simply put, the majority of women physicians do not appear to work enough hours earning the physician-wage premium to amortize that profession’s higher upfront investments.

This is also backed by this study:

This paper documents and studies the gender gap in performance among associate lawyers in the United States. Unlike most high-skilled professions, the legal profession has widely-used objective methods to measure and reward lawyers’ productivity: the number of hours billed to clients and the amount of new-client revenue generated. We find clear evidence of a gender gap in annual performance with respect to both measures. Male lawyers bill ten-percent more hours and bring in more than double the new-client revenue. We show that the differential impact across genders in the presence of young children and the differences in aspirations to become a law-firm partner account for a large part of the difference in performance. These performance gaps have important consequences for gender gaps in earnings. While individual and firm characteristics explain up to 50 percent of earnings gap, the inclusion of performance measures explains most of the remainder.

Even though the equal pay act has existed since 1963, pressure from feminist groups continue to attempt to destroy equality. It was normal that women take a few decades to get close to men’s wages since even when you first passed the bill that didn’t suddenly bring women’s skills up to men’s standards, it had to take awhile. Yet this movement persists, earlier this year they tried to pass the “Paycheck fairness act” but thankfully the senate didn’t go for it.

If after all this time feminists have been masquerading equal pay under the veil of equal opportunity then I have a better approach for equal wages. Mandate women’s work hours to mirror mens hours! We also could try force the other sex to change, force men to work less hours!

Moving further up on the ridiculous scale: Women take some days off after giving birth, and even if parental leave is also a thing, the reality is women take more leave than men. So we could fix the wage gap by mandating all women to have abortions every time! Or biologically change men so that they can also have babies!

So there is no problem, meritocracy is at work, is it really a problem that women don’t prioritize wealth as much as men do?  I don’t think so. The market isn’t perfect but I have not seen conclusive aggregate evidence of market failure in this domain.

edit: here’s an interesting speech by Larry Summers on the topic http://www.harvard.edu/president/speeches/summers_2005/nber.php

Shut up Romney, here’s why trickle down doesn’t work!

So you often hear right wingers advocate for cutting tax rates on the rich. Bush did this and so were born the “Bush Era” tax cuts. And now you have Romney advocating for the same thing if he is to be elected.

The logic they apply is probably not bad at all at face value. If you cut taxes on the rich then they will spend that money to create jobs by investing in society.

What it does miss however is one of the first things you read in an economics text books: a company will hire an employee if it can extract more value out of them than it has to pay them. So this means that the only thing that matters is how productive the employee is. The minimum wage creates a minimum level of productivity required so after a certain level of productivity is reached, then a company would hire. All of this is of course under the conditions that the markets the company is operating in are expanding or that it thinks it can steal market share with these new employees.

But maybe an employee isn’t productive the moment you hire them, but they have to take training and will learn on the job, so the company has to take a loss, and maybe the company can’t afford the loss(even though companies are sitting on record levels of cash in their bank accounts). And in some countries/states interning for free is illegal, so they can’t get rid of that loss or reduce their risk by evaluating candidates with on the job testing.

However companies can also borrow money, either from banks or by giving out bonds or whatever. And these days the cost of borrowing money is ridiculously low, a company should easily be able to find a 1% interest rate. But Romney is right, he will create jobs, it will just be the jobs that previously could not work because the company was not able to extract more than 1% value out of that employee. An example is someone who’s going rate at the job market was 70k but with the current interest rate they would only have been able to pay them 69.3k… a very rare occasion indeed, somehow the company could not afford to pay 700 dollars/pounds/whatever more, which would be much less with average incomes. So the jobs will ONLY be generated for cases where they can spare 69.3k but can not 70k, and these tax cuts are only for the richest, who are likely to have millions… so whats the probability that people with over 100k(in all likelihood, people who are millionaires) income, can’t afford to spare 700 dollars? not very high…

Does Basel III make sense?

In the past couple of decades the sung mantra for deregulation has been overwhelmingly dominant yet today light touch regulation is shown to increase volatility in growth. With a new era of regulation taking place, perhaps the single most globally important measure is BASEL.  Although BASEL II was never fully fulfilled in the US, BASEL III is now in line to be implemented it’s important to understand the risk management mechanics of this series of regulatory implementations. BASEL aims to recommend to banks how to be solvent by creating a system that evaluates risk based on leverage and the rating of assets. The innovations of  BASEL III is that it introduces a buffer conservation which restricts shareholder compensation if the equity level is too low and a counter cyclical buffer which is an attempt at creating a more dynamic capital requirement which increases if the credit to GDP ratio rises. This is a great step in making BASEL more dynamic but as long as arbitrary static figures exist within it it’s likely to not be efficient.

It’s a romanticised notion that this is actually a policy which would reduce risk by limiting the amount of exposure allowed. However this can also be seen as a transfer of liquidity risk. From a retail banks point of view, the liquidity risk is passed to the citizen as he can now borrow less. The static figures of capital requirements also assume an excessive amount of knowledge as to how many good investments are really available, relying excessively on a top down approach measuring style of how much banks should lend. Additionally limiting leverage based on risk weight actually reduces diversification because it encourages investment in low risk assets as the number of low risk assets has not increased, this reduction in diversification could increase risk in the long run. This system also allows for an excessive amount of leverage if too many low risk assets are used. In the worst case scenario fruitful investment will not be undertaken and in the best case scenario predatory lending will decrease, having imperfect knowledge means at least one of these will occur.

However having risk weights also encourages banks to want to pass on the risks to other bearers who might not be optimal holders. For example holding mortgage-backed securities today on a balance sheet is a very expensive endeavour which encourages the passing of this risk. BASEL could have been the culprit behind the reckless behavior that caused the financial crisis since it indirectly encouraged securitization because of its ability to skip over capital requirements. This goes contrary to an optimal framework because to reduce risk on securitized assets the optimal practice is to keep them with bearers who have the most information about them, and the longer the chain of risk selling, the more fragmented and scarce on information on the product becomes. A more thought out policy would take measures to ensure that the holders of the risk were not too far from the entity whose risk they are holding. A more bottom up approach such as giving regulators guidelines on systemic risk is a much more potent way of controlling it. To boost regulatory performance, there should be incentives such as bonuses based on low systemic risk measurements to ensure there are parties actively pursuing the interest of taxpayers.