Black Swan?

The past couple of days remind a lot of when those Bear Stearns Credit funds went under: massive panic about something in an esoteric corner of the market that was viewed as being a non-issue appearing on the front page of the FT & WSJ, followed by dip-buying off the lows as participants attempt to shrug off the news.

I'm sure you'll remember that Suprime was considered to be "contained" (I think that was the choice phrase) and would not be a broader issue for markets. Indeed, $250bn of securities were clearly not enough to land the financial system with $3trn of losses. But what did happen was that market participants were forced to do their homework and did not like what they saw. The point being that there were wider issues that were brought to view and the events in themselves led to large strains across various segments of the financial system.

The reason I bring up this similarity is that an excellent article (from the good people at Nomura) I read today hit the nail on the head: this is a BLACK SWAN. It points out that the issue here is willingness to pay, not ability to pay. And that, I think, is the heart of the matter. The UAE clearly has ample amounts of money. The last time a sovereign defaulted from being unwilling to pay was Equador a couple of years ago (recall Chavez's socialist revolutions across South America) [and of course Russia in 1998]. But Equador is an irrelavent country on the periphery and that was at a time when the banking system was not in a bad state.

Dubai is different because the West is exposed to it in not insignificant size. Sure, the size in itself is not an issue (just as $250bn of subprime securities were not an issue in themselves for the banks), but I would draw attenion to the willingness to pay issue. Sovereign defaults usually occur when either a country has an inability to pay, or the market believes them to have an inability to pay - there is a classic-style run on the capital account and a crisis ensues. In recent years there have been very few countries that fell into this bracket (the Baltics, Iceland) as most EM countries have built up very large FX reserves in recent years (in addition, the presence of China has ensured that commodity prices - EM countries' main exports - have remained high, thus reducing the risk of a balance of payments crisis). So EM countries have the ability to pay, but do they all have the willingness to pay?

What I am trying to say is that is this event going to force market participants to re-examine EM risk premia? I don't think that it is a scenario that can be ruled out.

Clumsy Thoughts on the Front-end

The front-end today has a feeling of capitulation/"get me in!", with the 2yr yield down to a low of 0.67% (!), the lowest since the Dec08/Jan09 deflationary panic and the 14-day RSI at its lowest since the bottom in yields on 16th Dec (the day after the FOMC). With GC trading 15bps the yield pickup of ~2bps/month from here just can't compensate for the potential risk that growth either rebounds strongly or inflationary worries come to the fore (TIPs 5Y5Y still near the top of their range).

To do a very rough back-of-the envelope approximation, term-risk premia from the back-end Eurodollars looks to be about 15bp/year, meaning that over historical carry, there is a mere additional 0.9bps per month pickup over the next two years. Regardless of your view of the Fed being on hold indefinitely, there is very little juice left in this trade.

To look at it another way, Mar11 FOMC OIS is trading at 1.159%, or 82bps of tightening (subtracting risk premia and Effective funds) . A "normal" tightening cycle would involve ~250bps over a 1 year period (ie 25bps at every FOMC meeting), so that would imply around a 1 in 3 chance that the Fed has begun its hiking cycle by Mar11, but the timing of this and also its magnitude are uncertain. If rates are to be "normalised", for example, that might require a series of 50bp clips, given that we are starting from a much lower level. For example, 350bps in 1yr would be 50bps/meeting, and indicate just a 23% probability that a rate hike cycle had begun by Mar11. Conversely, the fact that we are recovering from a financial crisis might mean a much slower normalisation.

Perhaps a "better" way to think about this is to consider the probability of a hiking cycle beginning in any one single month (I assume that 50bps would be the first move, but it could easily be 75bps). In the 15month period to March 2011 there are about 10 FOMC meetings, so this translates to 8bp per meeting. Or in any single month there is about a 16% chance that the Fed begin a rate hike cycle. That is slightly lower than the approximation that assumed 50bps/month, but in the same ball-park, so we can assume the two approaches are roughly consistent with each other.

But what is clear from both approaches is that the market is attaching an extremely high probability to the idea that rates will be on hold well-into 2011.

The Yen, Flow of Funds and the Stock of JGBs

I've been meaning to put this piece together for a while, but couldn't face ploughing through the Flow of Funds data on the BoJ's website - a traumatising exercise indeed. There has been a lot of noise recently about Japan's Government Debt soaring above 200% of GDP and John Paulson & David Einhorn have been telling anyone that listens that interest rates in Japan are going to rise dramatically, spuring a default and possible currency crisis. They tell a good story that is certainly not outside the realms of possibility and they are both extremely smart individuals, but I think they have got this wrong. As a warning, this is a bit wonkish...

There are several arguments for a sustained sell-off in JGBs. First, the DPJ have announced that they will be ramping up fiscal stimulus (as part of their rebalancing strategy) which will result in a signficant jump in issuance, sending the fiscal deficit to nearly 11% of GDP and the stock of government debt to well over 200% of GDP. Second, the collapse in USDJPY over the past couple of years has led many to argue that the Yen is overvalued - PPP measures support such a conclusion, but as will be detailed below, the reality is more subtle. Third, the tepid rebound in Japanese Industrial Production in the face of dramatic rebounds in, for example, Korea has led many to argue for competitive devaluation. Fourth, net portfolio flows in recent months suggest that foreigners are abandoning Japanese assets, while Japanese continue to accumulate foreign assets (see below chart). And Fifth, that the combination of these factors will mean that financing the deficit will require much higher fiscal premia and the possibility of a fiscal crisis is thus very high.

But these arguments make several assumptions about the structure of Japanese capital markets and neglect to consider the fact that Japan runs a large (although, admittedly smaller than it was a couple of years ago) Current Account surplus. First, the issue of Yen valuation: indeed PPP measures suggest an overvalued currency, however, long-run REER measures (see below JPMorgan's Broad REER Index) suggest that the level of the Yen is about right - the real issue was the severe undervaluation of the Yen in the period 2005-8. An optical focus on the USDJPY rate rather than broader measures is probably responsible for this conclusion.

For many years, Japan has recycled its Current Account surplus by purchasing foreign assets - especially USTs. As can be seen from the below chart from the US Treasury's TIC data (brown line is Total Foreign Holdings of USTs, white line is Japanese holdings), this has accelerated over the past couple of years, presumably as a result of rising risk aversion and a desire to "average in" as the USD fell. But the fact that these purchases have continued at about the same rate as during the periods of extreme risk aversion despite the fact that risky asset markets have recovered much of their lost ground suggests something else is going on.

Usually, these foreign purchases have been left unhedged on an FX basis as the cost of the hedge has historically been quite high (selling USDJPY and funding it day to day or via an FX Forward resulted in paying significant negative carry). But this is no longer the case: since central banks globally have slashed rates, there has been a convergence of short-term interest rates. Specifically, it has never been this cheap to fund a short-USDJPY position: the Tom/Next Yen FX Swap is essentially zero. So I believe that Japanese financial institutions have been playing a carry trade whereby they have bought long-dated USTs and hedged the FX risk by selling USDJPY and are funding it short-term. And it is for this reason that those that have been (fashionably) short the Yen have been repeatedly frustrated this year. Such weakening is unlikely until either (i) long-term UST yields converge sufficiently with JGB yields, (ii) the Fed hikes rates sufficiently to make funding short-USDJPY positions more expensive, (iii) portfolio flows move sufficiently negative as to offset the recycling of the Current Account, or (iv) Japan ceases to run a Current Account surplus. It is clear that there is a long way to go before the former conditions are met, and given foreigners own such a small amount of Japanese financial assets (a mere 6.8% of JGBs are foreign-owned, in stark contrast to 35% of Gilts and 50.3% of USTs!) it is unlikely that the third condition will be met. The final condition is perhaps the only one that seems reasonable - however, if the broad rally in risky assets continues, even in the face of central bank intervention, major competitor currencies (such as the KRW) should appreciate and reduce the pressure on the trade balance.

Regarding the issue of whether increased issuance of JGBs can be financed without recourse to higher interest rates or a slide in the currency, the key issue here is FLOW OF FUNDS not STOCK OF JGBs. And it is here that I think Paulson & Einhorn's arguments fall down because they are talking about the stock of JGBs, which as a proportion of GDP is certainly approaching dizzying levels that have in some cases historically been associated with default, but in others (notably during wars) have not. Those who have read their financial history will note that there have been very few instances of sovereign debt crises where the country in question ran a Current Account surplus. In fact, off the cuff, I can't think of any. There is a reason for this: a Current Account surplus represents an excess of savings, and in Japan's case, the Government's borrowing is more-than offset by domestic savings. The point being that government liabilities can be funded entirely domestically and the currency is only at risk if the domestic population suddenly decide that their currency is worthless. There are plenty of instances of this occuring historically, but they have always been accompanied by hyperinflation, whereas deflation is entrenched in Japan.

_

One of the key arguments that the bears put forward is centred around the idea that the Household's savings rate has declined dramatically as Japan's demographic problems materialise, and thus there will be no household financial surplus to fund the very large 11% government deficit. That household saving will not be able to fund the deficit is certainly true to an extent, however, given the damage done to household balance sheets over the past couple of years, it would be reasonable to expect some increase in saving to repair this damage. But much more importantly, their argument neglects to consider the financial surplus of private sector corporates. Specifically, corporates have been squeezed from all sides: the Yen has rallied sharply against major competitors, the global recession has suppressed external demand and the DPJ's fiscal stimulus has been aimed squarely at consumers, rather than at them (past stimuli have usually been comprised of corporate tax cuts and infrastructure/pork barrel policies). Faced with such headwinds, corporates have no choice but to build their savings - in response to the transition of the Japanese banking crisis into its acute stage in 1997/1998, corporates rapidly ramped their precautionary savings and slashed CapEx (see below chart of Financial Surplus/Deficits from the Flow of Funds data - the BoJ altered the construction of this data in 1999 so the crossover levels may not be perfect, but will not detract from the overall argument). Indeed, given the large amount of spare capacity both domestically and also globally, it is unlikely that corporates will be looking to invest in the near-term. Thus, corporates holdings of JGBs are likely to rise both directly and indirectly (via their bank deposits being recycled into JGBs by the banking system). There is a slightly more subtle corrollary from this effect. An increase in corporate savings is equivalent to a fall in demand for loans from financial institutions. As a result, bank loan-to-deposit ratios will fall further - they are already below 80% in aggregate - and as has historically been the case, financial institutions will increase their share of the stock of JGBs.

To conclude, those who expect the Japanese Government Debt to GDP ratio to result in an imminent crisis are confuing Stock and Flow of Funds. It is undoubtably true that the ratio is approaching unsustainable levels, but it is not clear whether a catalyst will present itself to force the issue. The simple existance of Japan's Current Account surplus and structure of its capital markets (where 93.2% of the stock of JGBs are held domestically, and only 5.2% of these directly by households) make it extremely unlikely that a sovereign debt crisis can occur [UPDATE: As reader GE succinctly points out, Japan will never default on its own people]. Additionally, the low cost of funding external carry trades in, for example, USDJPY means that there is additional support for the the Yen in the form of FX hedging, preventing the exchange rate from acting as a lever to force the issue. Finally, note that this FX hedging by Japanese financial institutions also allows the BoJ to increase its purchases of JGBs without risking weakening the currency (as has been the case with the US and UK versions of Quantitative Easing). To summarise, those attempting to short JGBs and the Yen on the expectation of a sovereign debt and currency crisis are likely to lose money like those before them did on numerous occasions in the 1990s.

June 2007 Redux

I have been hearing a lot of things recently that remind me of June 2007. Bearish sentiment is perhaps not what the AAII Bull/Bear survey indicates (not too surprising given is a better gauge of retail positioning given the focus on newsletters).

Specifically, over the past few days:

"The Fed is long stocks, why fight them?"
"There is liquidity everywhere"
"Liquidity will search for yield"
"Bad data is good because it means rates are lower for longer"
"There is a structural bid from Real Money"
"There is huge amounts of cash on the sidelines"
"Eastern Europe can still rally if there is a sell-off in risk" (yes someone even tried to
convince me of this!)
"Risk has to rally at least into Q1"
"Rates on hold mean you need to move out of cash into risky assets"
"There's nothing to stop SPX hitting 1200 by year-end"
"Equity markets will climb a 'Wall of Worry'"

Compare with some examples from June 2007:

"The Fed has got your back"
"There is liquidity everywhere"
"There is a thirst for yield"
"There is a structural bid from Structured Credit"
"Bad data is good because it means that the Fed will cut rates"
"Carry & EM won't be affected by a US slowdown, they can continue to rally"
"EM can decouple from the US"
"Subprime is 'contained' "
"Equity markets will climb a 'Wall of Worry' towards 1600"

Breakevens to the Fed: "Your move"

Today is perhaps the most interesting day in Rates markets I can remember since the Fed first formally announced that it would begin Quantitative Monetary Easing in March. It is interesting because 5y5y TIPS Breakeven Inflation looks about to close at a new high around 2.9%. This is important because it is outside the accepted range considered to be "well-anchored" and would be the first time that they have closed outside of this range.

We have been here before on several occasions over the past couple of years. The market has often interpreted the Fed (and policymakers in general - excluding the ECB) as always "going for growth. Many will recall the rants of Jim Rogers et al crying that the Fed was printing money and trashing the Dollar and that Gold was the only sane investment for those wanting to preserve their purchasing power. The recent break of Gold above 1100, cheered on by several notable hedge fund managers, and supported by several Emerging Market central banks, is adding to this perception. Will the Fed tolerate this given the criteria laid down during last week's FOMC meeting.

There are a few examples that I want to discuss, along with the Fed's responses to these moves. Firstly, in mid-January 2008, as equity markets were melting down as rogue trader Jerome Kerviel's portfolio was liquidated, TIPS breakevens widened significantly in response to the Fed's intrameeting cut of 75bps - an unprecedented move up to that point. The curve very quickly moved to price in a high probability of a 100bp cut at the end of January. However, the Fed - perhaps in response to this widening, as well as moves in the USD and Gold - disappointed markets. Breakevens duly tightened again back into the range.

Secondly, as Bear Stearns was undergoing its final liquidity squeeze in mid-March 2008, breakevens again widened to an intraday high of 2.94% on 14th March as the market began to price in the possibility of a 125bp rate cut from the Fed. With a rescue orchestrated for BSC, the FOMC once again disappointed, and breakevens returned to their range.

The next example comes in the week following the G7 meeting of late-April 2008 in which currency market volatility was discussed, but the statement did contain anything more than a vague promise to cooperate on exchange rates and the usual boilerplate around FX volatility. The FX market viewed this as a "carry on as before" message and duly took the USD to new lows. During this period, TIPS once again widened above 2.8% intraday. Shortly after, Fed rhetoric on inflation was stepped up and the front-ends of curves collapsed as rate cuts were priced out (cumulating in Trichet's summer "present"), TIPS returned to their range.

The final example is 15th September 2008, the date that Lehman Brothers filed for Chapter 11. Many financial market participants initially viewed the event as an extreme Dollar-negative (myself included) as a classic EM-style run on the capital account - by virtue of refusing to fund the banking system - would require a full fiscal bailout of the financial system and associated debt monetisation. 5y5y TIPS breakevens traded to an intraday high of 2.935% that day before collapsing in October & November under the weight of dealer deleveraging and a view that a deflationary outcome was inevitable. But an event that far fewer remember is that at the FOMC meeting that week, despite the curve pricing in rate cuts in response to the Lehman failure and other associated fall-out, that the Fed kept rates unchanged.

It is clearly evident from their prior behaviour that the Fed is uncomfortable with inflation expectations straying too far from their implicit target. It appears to me that a chain of events has been set in place whereby the Fed (and policymakers generally) have told financial markets that they will not be enacting exit strategies for a significant period of time. The size of the output gap is cited as the reason that inflation will stay low - and is one with which many participants (including myself) agree with. But something is wrong. If this is the commonly held view, then why are breakevens soaring to new highs that indicate that the market expects higher inflation? A dangerous game is being played whereby the market is calling the Fed's bluff - will the Fed step up to the table? The market knows that the Fed knows that it cannot afford even to let expectations stray a little - because as soon as they stray a little and nothing is done, they will stray a little more, and so on. Central banks have cashed in a lot of the capital they have built as inflation-fighters over the past 30yrs, and it is remarkable that it has taken until now for it to be seriously tested.

The liquidity-driven rally in everything that is not the USD has been given an implicit "OK" by policymakers. Will they be "OK" with the side-effects?

My sense is that we are on a collision course with a policy response.

Unemployment Jumps and Recessions

Today's payroll numbers were slightly worse than expected, but not terribly so. However, the unemployment rate jumped by 0.4% to 10.2%, a move that is worrying in several respects. Firstly, from a Consumer Sentiment standpoint, it is not encouraging - especially given the high correlation between sentiment and consumption (given that Consumer Credit has been shrinking for a while now, it is not obvious where the financing for consumption growth will come from). Secondly, the Stress Tests specified a peak unemployment rate of 10.3% in the "more adverse" scenario. Given the acceleration in the unemployment rate, it is clear that the trends in employment are not favourable, and a further deterioration seems likely. This could very well bring concerns about the writedowns back to the fore.

But most importantly, there are merely two examples since the official data series was first constructed in 1948 in which unemployment jumped 0.4% month-on-month and was not in recession: 1986 and and 1995. Both of these were mid-cycle slowdowns in the midst of high, above-trend periods of growth. This clearly cannot be argued to be the case now.

In fact, in the observation period, the US was in recession 5.5% of the time and experienced periods in which the unemployment rate increased 0.4% and the economy was in recession 4.6% of the time, implying that the empirical probability that the US is currently in recession is ~82%. Clearly the consensus view that the recession was exited in June 2009 is either wrong, or we are currently entering the much talked about "double dip".

Oil, CPI, Inflation Expectations and the FOMC

The FOMC statement was largely taken as "dovish", with rallies in EM, SPX, TIPS breakevens and a re-steepening of the curve. But a closer look at the statement, as pointed out by the FT's Krishna Guha (http://blogs.ft.com/money-supply/2009/11/04/final-reflections-on-the-fed-statement/), suggests that the market may have misinterpreted the statement. Guha points out that the committee, whilst retaining the key language on rates being kept low for an "exceptional" period of time (generally assumed to be six months), they attached conditionality and outlined the criteria that would push them to hike in the next six months.

Specifically:
- low rates of resource utilisation (i.e. - the unemployment rate).
- subdued inflation trends.
- stable inflation expectations.

Now, while the unemployment rate is unlikely to come down anytime soon, the latter two conditions are not as certain to remain unbreached. Firstly, the liquidity-driven rally across risky assets this year - along with the infatuation many have with Chinese commodity demand - have resulted in commodity prices retracing a large amount of their 08H2 sell-off. In particular, the Oil price is one of the main drivers of headline CPI, and the base effects are about to become extremely large. For example, if the Oil price stays at its current level of $80 into year-end, its year-on-year increase will be just under 150%. The (albeight naïve) chart below highlights the coming surge in headline CPI towards a 3%-handle by January, and beyond if Oil continues to march on (which is not inconceivable if the naked liquidity trade continues).
While core inflation has been trending lower (in response to the size of the output gap), and the market knows that it this that is more important, the weight of positioning in the "lower for longer" trade may be unable to withstand such an acceleration in the headline number. Indeed, most will remember the ECB's reaction function to the march of Oil into July 2008 and the associated collateral damage across asset classes: it is clear that the potential for a "rush to the door" is there.

Secondly, the Oil price has affected inflation expectations before, and it will affect them again. The below chart of the University of Michigan's 5y Inflation Expectations survey, and shows that last year these rose above their historic 2.75%-3% range. There has been much research that concludes that surveys of inflation expectations are highly correlated with coincident inflation numbers, and it would be unwise to expect no effect upon these gauges as the headline begins to accelerate.
The Fed also pay significant attention to market-based inflation measures, such as TIPS. As the deflation scare took hold in 08Q4, TIPS break-even inflation rates collapsed, but have since recovered much of their ground. The outright TIPS are not as useful for determining expected inflation due to issues of liquidity, financing and inflation risk premia, but the forward-starting TIPS do not suffer from all of these problems (though, they are still not perfect). The below chart shows that 5y5y forward breakeven inflation has returned to the top of the range generally considered to be "anchored" - of 2.25%-2.75%. Indeed, breakevens widened another 6bps in the aftermath of the FOMC statement.
Finally, the USD has been in a downtrend and is approaching the levels at which last year caused concern for policymakers - indeed, Gold has surpassed its prior peak, and a break of 1100 would likely lead to further USD selling more broadly. The key issue for policymakers is the extent to which this sell-off begins to affect inflation expectations via the feedback loops into Commodities and back again - much as was the case in the first half of 2008. Yesterday's reaction across asset classes (as discussed above) was particularly telling in this respect, and the risk is - that with the conditions for a policy move having been set - that the USD sell-off vs other currencies and Commodities accelerates and forces the Fed's hand, just as in the second quarter of 2008. In such a scenario, the risk-reward must be to hold shorts at the front-end of the curve around six months out. As ever, the Fed's reaction function will be to first downplay an acceleration in inflation, but such moves usually result in yet more USD selling which exacerbates the problem. Perhaps short the Dollar and short Equities is an effective way to play what will be an eventual self-defeating acceleration of the liquidity play.

Regulation

This post is a bit off-base from what I normally write about.

There is a regulatory battle currently going on in Washington pitting the (largely Wall Street-friendly) Treasury against the (largely FDIC-friendly) Democrats, led by the enigmatic Barney Frank. Much has been discussed elsewhere about the pros and cons of reviving the Depression-era Glass-Steagal Act, so I won't go into too much detail there. However, I will put forward a simple counter-argument to claims by those (such as Gordon Brown) that reviving the Act won't help, because Northern Rock was a retail bank and Lehman Brothers was an investment bank, yet they both failed. This argument neglects to consider the impact of the ability to use balance sheet: commercial banks could offer their balance sheets in securitisation and debt/equity issues, whereas investment banks could not. So investment banks were forced to move into ever-risky ventures, while in moving into the securities & derivatives business, commercial banks were putting their own balance sheet at significant risk. Furthermore, the march of financial innovation encouraged their retail arms to lend to more risky entities and the ability to sell these as ABS allowed them to feel much more comfortable with high LTVs and borrow more on the wholesale markets. It is blatantly obvious to anyone with a brain that abolishing Glass-Steagal digitally increased the aggregate risk the financial system was able to take, as well as increasing its interconnectedness.

But that is not the only problem. The increasing march into exotic derivatives as well as the exponential growth of dealer inventories of derivatives overtook the expenditure on internal infrastructure. As an example, several booking, settlement and payment systems for derivatives at some institutions are nearly 20yrs old! These creaking systems have been gradually updated by "bolt-ons" and "sticky-tape" solutions but they could not keep up with the ever-increasing back-log of trades. I would expect that the problem is even worse in the very large banks that have endured years of mergers. It does not help that morale in back-offices is usually very low. IT and infrastructure spending increases to modernise this archaic structure needs to be significantly increased.

Furthermore, there is no real industry standard for valuing even the most vanilla of OTC derivatives - an issue that becomes exceptionally complex when taking into account counterparty risk and Mark-to-Market collateralisation. Listing vanilla derivatives on exchanges removes this complexity, increases price transparancy as well as significantly reducing interconnectedness in financial markets. I have witnessed several attempts by the exchanges to introduce contracts that very closely replicate such OTC instruments, but the banks have repeatedly stonewalled. If we are attempting to change the regulatory structure in order to reduce systemic risk, there is simple no excuse for not doing this.

Exotic derivatives, and more custom derivatives, are of course a different story. However, moves such as JPMorgan's release of its CDS model into the public domain should help to gradually establish some valuation standard. Regulators should aim to insist full collateralisation of mid-point valuations of the two counterparties, and for uncollateralised transactions insist that capital charges are adequate. I note that many banks have now set up Credit Valuation Adjustment (CVA) desks - these attempt to try to hedge firm-wide credit risk on uncollateralised MTMs in the interdealer derivative market. Some banks have also introduced P&L accrual rules on longer-dated trades. These are steps in the right direction.

The Frank proposal (which is heavily influenced by the FDIC) is to set up a systemic institution resolution fund, and Geithner's argument that having it there will merely increase moral hazard does not really stand up. The Frank proposal aims to discourage firms from being Too Big To Fail - surely this is a good thing? There are plenty of examples of the "financial supermarket" model failing: American Express, Travellers, Citi, RBS etc. As Mervyn King once said (and I am far from his biggest fan), "Too big to fail is too big to exist". It really is that simple.

The leverage issue is far more complex. There are far too many examples in history of financial systems becoming over-leveraged and becoming the epicentre of financial crises - if you haven't already read it, Kindleberger's "Manias, Panics & Crashes" will supply those examples. The key issue is that individual banks exhibit no control over systemwide credit creation - they only care about maximising their own profits, so it natural that they will lend as much as they can in order to make more money. In absense of competitors, their lending decisions will be "prudent", but the introduction of competition encourages lending to riskier ventures. There is nothing wrong with that per se, but notice that the overall amount of credit creation is larger in this case. There is plenty of evidence that government allocation of resources is suboptimal, however, government control of aggregate credit creation could be one sensible means of preventing overleveraging and asset bubbles. In such a scheme, the Fed could target credit growth in aggregate use Window Guidance to divide this up between banks, who would then use their individual expertise to decide which entities to lend to. This leaves lending decisions to the free market and macroeconomic policy in the hands of the (supposedly) independent central bank. Of course, the dividing up of growth targets is an issue here as banks are incentivised to go for market share, which is the main problem with the strategy. An alternative suggestion has been for counter-cyclical capital requirements and leverage ratios which is similar to the above in that it tries to indirectly control credit creation by by "leaning against the wind". This, too, is a no-brainer.

Changing topic slightly, it is striking how much legislation has been proposed globally over the past few weeks on the regulation/bonus/banker-bashing front. I can't help but think that recent stories of bankers calling up estate agents and scooping houses up, and a seeming determination to pay bonuses "come what may" in the face of such outrage has brought this on. Governments in their bailouts were generally hands-off in the face of popular demands for bonus curbs, relying on merely capping bank Boards' pay. But the "business as usual" attitude of the past few months has embarrassed politicians into action, and for that, we all will suffer. It never ceases to amaze me why bank employees were not issued large amounts of equity capital in place of cash bonuses, aimed at replacing depleted capital, allowing cleansing of balance sheets and ultimately a break of ties with their State owners. In such a situation, pre-provision earnings would result in these bank share prices flying, reaping rewards for all stakeholders: employees, management and taxpayers. Sigh. I digress...

The Belgian windfall tax on bailed-out bank profits was swiftly adopted by the French - a country with a significant market share of global banking - and now there is no longer a worry that "he who regulates first loses market share". The latest incarnation of bailouts of RBS and Lloyds appear purely designed to kill their investment banking arms. Whether or not they find loopholes allowing them to pay bonuses, these are likely to find their way into the press and create political firestorms. Such institutions will not be able to fight for talent and they will go back to being "boring utility banks" following the 3-4-3 model. This seems to be "de facto" Glass-Steagal. Coming on the back of the break-up of ING, it is clear that there is now no real obstacle to breaking up large institutions in the US either. The Frank legislation comes on top of these.

Regulators are getting serious.