Pariah profits in an age of ‘negative carry’ | FT Alphaville

Pariah profits in an age of ‘negative carry’

Here are some charts we knocked up (in our usual MS paint, so excuse the pixelation) to try and explain why the banking system’s biggest problem may lie in ‘negative carry’ — a phenomenon that would make investment-focused lending unprofitable, pushing the onus instead on pariah-profits extracted from economically destructive practices.

We begin with the following (click to expand):

Consider the blue a representation of assets, goods and collateral, and the yellow the amount of money (or equity) that exists in the system as a result.

The first two charts reflect the conventional banking model. At the heart of this lies the concept that money has a time value attached to it.

Indeed ask any banker what determines the value of money, and they will tell you it’s money’s ability to generate a positive carry for anyone who is prepared to part with it (lend it) over time.

Throughout history money has always been associated with such a positive carry. This is linked, we imagine, to the world wanting to guard against the risk of scarcity in the future, as opposed to the risk of oversupply. Certain eternal truths feed this presumption: people cannot work forever, the system always needs more goods to satisfy a growing population, it’s best to plan for the risk of unexpected scarcity and lastly, people’s desire for “more stuff” is very hard to satiate.

A disequilibrium consequently plagues the market.

The flip-side of the disequilibrium, of course, is that people presume money will be more plentiful than goods over time. A trend which results in a subtle inflation.

“A Lannister always pays his debts”

Contrary to popular belief, the above disequilibrium and positive carry trade can be exploited by anyone who is willing to take steps to balance today’s reality against tomorrow’s expected reality (chart 1).

The easiest way to do this, of course, is by balancing tomorrow’s shortage of goods against today’s relative under supply of money. So by extending credit at your own risk (shorting money) on the hope that it leads to the increased production of goods. We call this process investment lending (chart 2).

And you don’t even need to be a bank to profit from positive carry in this way (note the growth of the shadow banking industry in recent years). There are in reality no barriers to entry. Though significant capital to back one’s word does helps. As does being known for paying your debts on time and never defaulting.

A banking license may be helpful too (though is not essential).

Base capital, of course, is only really needed to reassure people that your credit is good. This is essential if the credit units you extend to people — created by you out of thin air — are to be ubiquitously accepted for settlement of payment purposes in the economy. Base capital may also be helpful if and when your assets fail to match your liabilities. Indeed, you can dip into your capital buffer to cover short-term liabilities without putting your reputation at risk.

It’s worth pointing out that before central banking became de rigeur in the economy, banks only needed base capital and a good reputation to operate.

In many countries, like the United States, this led to a veritable cottage industry springing up in banking. Due to its unregulated, fragmented and local nature, the banking industry unfortunately became prone to liability and asset mismatches (that is, to going bust). Since banks only had a compartmentalized view of the market, rather than the system’s needs as a whole, they tended to make bad investment choices which at times collectively resulted in either oversupply or undersupply of credit in the system. This ultimately led to fears of insolvency and major banking panics.

In a bid to bring order to the chaos, authorities decided to create central banks. These, it was hoped, would regulate the overall amount of credit in the system and act as lender of last resort to banks suffering from a temporary shortage of liquidity.  In so doing unnecessary insolvencies, it was hoped, would be avoided, and wider panics would be mitigated.

A retail banking license is thus no more than an extra layer of security for a bank. It represents a bank’s right to seek support from the central bank and in so doing helps build confidence in the institution in question.

Once the confidence is established, there is no constraint on how much credit the bank (or non-bank) can create, especially in a fiat money system. With the central bank regulating and offering on-tap liquidity, only bad lending choices are supposed to lead to the sort of principal destruction (asset writedowns) that can cause insolvency.

Bridging the balance

In chart 3 we represent the situation as it was in 2008. From a central bank’s point of view it looked very much as if banks had — on a system-wide basis — over shorted the credit market. In other words lent more than they could possibly ever hope to get back. Asset writedowns were necessary. Some bankruptcies were also inevitable.

However, if enough liquidity was provided against those assets which had been made temporarily illiquid, there was a hope banks could be propped up until better lending decisions would start delivering positive carry profits, and in so doing recapitalise the  banking sector. (Note chart 4.)

The presumption was, of course, that the system’s anticipated money shortage in the future was the result of banks having made bad investment choices, which could no longer deliver the returns needed to cover liabilities. Better investment choices were needed.

In a bid to help banks out the central bank tried to steepen the yield curve to its maximum inflection point (by keeping it at zero on the short end and allowing the market to dictate longer term rates as usual). It was hoped this would help banks generate positive carry profits as quickly as possible.

Larger capital buffers, meanwhile, were dictated to stop banks  seeking multilateral central bank assistance in the future.

Which brings us to our next sequence of charts:

We propose that had this just been the case of a temporary liquidity shortfall, we would not still be battling the malaise. The above actions would have been successful.

Something else is clearly going on.

Thus what if the banking crisis is less about bad lending decisions and more about overly successful investment? (We appreciate this is not conventional thinking, and that many will find this idea sacrilegious, but please run with our hypothetical scenario — just for fun.)

First, consider some of the evidence. We know the Western economy has been plagued by overcapacity issues. Output gaps have been negative not only in developed countries, but on a global level.

As the Fed puts it, this means the economy has dropped below its potential.

Yet there is something different about this overcapacity problem compared to others in previous recessions. As the Fed wrote in 2009, this one seems to be driven by a supply (or happy) shock is not restricting productivity:

Movements in potential output reflect changes in the economy’s supply side, either in terms of productivity or labor supply. Productivity has continued to grow reasonably well during the current recession, in stark contrast to past recessions, when productivity typically declined. Indeed, using Gali’s (1999) method of identifying changes in potential productivity, we find that during this recession potential productivity has actually increased at an above-trend rate.

At the Bank of England attention is now firmly falling on this supply side quandary, and the degree to which the economic malaise could come to threaten capacity in permanent terms. In other words, the real economic cost of banking and monetary equilibrium. The degree to which the country becomes permanently poorer to keep banks profitable.

As our charts attempt to explain, this could be because in a negative carry universe — one in which goods, collateral and assets are expected to permanently outnumber money in the future — bank profits can only be achieved through pariah practices rather than lending. Banks are ironically encouraged to destroy capacity, disincentivse investment, borrow money from the economy rather than lend it, and hoard wealth. All phenomenons we are currently seeing. All phenomenons which are economically destructive.

One of the best illustrations of this topsy turvy world, meanwhile, is that corporate cash piles are rising,  with corporates not just weaning themselves off banks, but lending directly to the banking industry itself.

Banks are adjusting to the new norm quicker than most central banks release.

While these pariah practices may eventually lead to banks becoming profitable again, the question is at what expense will these profits come? This really is what central banks should be considering.

For now, unfortunately, it seems that most central banks are still pre-occupied with re-engineering bank profitability from a positive carry perspective. In fact they are doing everything they can to fight off the threat of negative carry. Interest on excess reserves being perhaps one of their most significant tools in this battle.

What they perhaps don’t appreciate is that even if they can induce short-term positive interest rates for the official banking industry, there’s an entire universe of shadow banks which are already suffering the effects of negative net interest income.

Related links:
The negative carry universe - FT Alphaville
The strange case of ‘funding-for-lending’ confusion - FT Alphaville
On the transfer of risk and the mystery of low yields - FT Alphaville
The ‘high-powered money’ problem - FT Alphaville
Draghi May Enter Twilight Zone Where Fed Fears to Tread – Bloomberg
Enough is enough of the age of consumption – FT