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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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…

Economics vs Politics. Is free trade any good?

Economics experts fight over numerous of things, it’s the shame of the profession. The fact is that anything can be proven if you use the right econometric techniques, the right time-period and the right data set. So coherent theories are in fact in many ways more important than empirical evidence. Regardless of the dichotomy in economic debate there is at least one thing that would be in the economic bible and that is Free trade.

Free trade just means allowing products in and out of the country without imposing tariffs. The rationale for tariffs is that you want people to buy products that are made inside the country so that money stays in the country and develops the domestic industry. However from the consumer’s point of view, why should he/she care where the product is made? Since if even if the Japanese car industry thrives, they will export their great cars to your country and raise his/her standard of living. Whilst putting tariffs on their cars would either mean the consumer has to either accept a lower quality domestic car or accept to buy the Japanese car anyway at a higher cost, which either way reduces your standard of living because you either have an inferior product or because you have less dispensable income.

The part the Economics profession usually forgets is the politics aspect of tariffs. The reason you might not want to have free trade is if you believe instabilities between two countries will occur. You don’t want Japan to be providing all your cars for you because if they decide they no longer like you and want to go War with you, they can block all their products from coming into your country and helping you. Depending on how good the environment in the country is for setting up businesses, it is likely that either another country will provide the products or domestic industry will emerge, however if the Japanese industry was dominant chances are that your new supplier will not be as proficient, and depending on the product it could have devastating effects on the economy, such as if the product was food, that domestic workers tried to replace without enough expertise and end up selling toxic food.

So tariff’s are rationalized as a bargaining chip between governments, if you believe that relations with two countries are not likely to fall then then free trade is without doubt the route to go. This would probably be the US and Israel or Cyprus and Greece. So China making everything nowadays is not likely to be problematic, unless one believes that they might one day use it against other countries.

Price gouging!

So my last post was about a critique of free markets so lets change direction. So what is price gouging? Its sort of like a limit on the profit margin you can charge, some states in the US have laws about how much margin you can make if there’s a disaster. So say a 10% margin limit means that if it cost you 100 dollars to come up with something you can’t sell it for more than 110. So why is this good? So you don’t get ripped off during a disaster, when your house is flying above your head, you probably don’t need some guy charging you 100 dollars for a bag of ice. On to the story:

A group of friends hear about a disaster hurricane event a couple of hundred miles away from where they are driving. So they decide to go buy packs of  ice for about a dollar each and drive down to the distressed area. They then stop in front of some residential neighbourhoods and start selling the packs for 12 dollars a pack. Lots of people run to them and start buying, then the police shows up and arrests them for price gouging. The people of the neighbourhood see this happening and they start clapping to support the police.

So what has price gouging accomplished? Its easy to think that these guys were being immoral and taking advantage of the people. But now lets use economics… there’s a finite amount of ice… so what’s the best way to give it around? The way to maximize utility, so give it to the people who need it most… so how do we do that? Some people want the ice to keep their baby formula the right temperature, others want it to keep their beer cold, others might want it for their medication.

We are actually fortunate that the price system comes pretty close to achieving maximum marginal utility, how does it do that? by maximizing profit, the seller’s profits are probably maximized by selling all the ice at the maximum price he can get away with. People who just want to keep their beer warm won’t be willing to pay so much as someone whose health could be on the line.  Would those friends even have showed up if the profit was capped at 10%? Would they spend hours driving to leave with a couple of dollars each?

The one disadvantage of the price system is that richer people will be negatively influencing the maximum marginal utility mechanism but in a given neighbourhood inequality probably isn’t very high and rich people might in fact still be inclined to think in terms of  long term “value for money”.

So all this not to say that all price gouging is bad, since there are many times were it is used to prevent fraudulent activity or times where everyone could have the same marginal utility.