Topic: Finance, Banking & Monetary Policy

Lessons from the Ayr Bank Failure

One consequence of the financial crisis of 2008-09 has been renewed interest in the merits of contingent convertible debt as a mechanism for equity bail-ins at moments of acute financial distress. Should it fail, a financial institution’s contingent bonds are automatically converted into equity shares. History suggests that convertible debt can help to preserve financial stability by limiting the spillover effects of individual financial institution failures.

A particularly revealing historical illustration of this advantage of contingent debt comes from the Scottish free banking era. From 1716 to 1845, the Scottish financial system functioned with no official central bank or lender of last resort, no public (or private) monopoly on currency issuance, no legal reserve or capital requirements, and no formal limits on bank size, at a time when Scotland’s was a classic emerging economy with large speculative capital flows, a fixed exchange rate, and substantial external debt. Despite this, Scotland’s banking sector survived many major shocks, including two severe balance of payments crises arising from political disturbances during the Seven Years’ War.

The stability of the Scottish banking system depended in part on the use it made of voluntary contingent liability arrangements. Until the practice was prohibited in 1765, some Scottish banks included an “optional clause” on their larger-denomination notes. The clause allowed the banks’ directors to convert the notes into short-term, interest-bearing bonds. Although the clause was seldom invoked, it was successfully employed as a means for preventing large-scale exchange rate speculators from draining the Scottish banks’ specie reserves and remitting them to London during war-related balance of payments crises–that is, as a private and voluntary alternative to government-imposed capital controls.

Contingent debt also helped to make Scottish bank failures less costly and disruptive. If an unlimited liability Scottish bank failed, its shorter-term creditors were again sometimes converted into bondholders, while its shareholders were liable for its debts to the full extent of their personal wealth. Although the Scottish system lacked a lender of last resort, the unlimited liability of shareholders in bankrupt Scottish banks served as a substitute, with sequestration of shareholders’ personal estates serving to “bail them in” beyond their subscribed capital. The issuance of tradeable bonds to short-term creditors, secured by mortgages to shareholders’ estates, served in turn to limit bank counter-parties’ exposure to losses, keeping credit flowing despite adverse shocks.

A particularly fascinating illustration of how such devices worked came with the spectacular collapse in June 1772 of the large Scottish banking firm of Douglas, Heron & Co., better known as the Ayr (or Air) Bank, after the parish where its head office was located. The Ayr collapsed when the failure of a London bond dealer in Scottish bonds caused its creditors to panic. The creditors doubted that the bank could could meet liabilities that, thanks to its reckless lending, had ballooned to almost £1.3 million. The disruption of Scottish credit ended quickly, however, when the Ayr’s partners resorted to a £500,000 bond issue, secured by £3,000,000 in mortgages upon their often vast personal estates—including several dukedoms. By this means the Ayr Bank managed to satisfy creditors, at 5% interest, as the Ayr’s assets, together with those of its partners, were gradually liquidated. In modern parlance, the Ayr Bank had been transformed into a “bad bank,” whose sole function was to gradually work off its assets and repay creditors while the immense landed wealth of its proprietors’ personal estates provided a financial backstop. Creditors were thus temporarily satisfied with fully secured, negotiable bonds, which were eventually redeemed in full, with interest.

We are unlikely today to witness a return to unlimited liability for financial institution shareholders. The extensive and effective use of contingent liability contracts during the Scottish free banking episode nevertheless offers important evidence concerning private market devices for limiting the disruptive consequences of financial-market crises. When compared to the contemporary practice of public socialization of loss through financial bail-outs, such private market alternatives appear to deserve serious consideration. Most importantly, perhaps, by encouraging closer monitoring of financial institutions by contingently liable creditors and equity holders, these private alternatives appear, in the Scottish case at least, not only to have made crises less severe, but also to have made them far less common.

This post is based on Tyler Goodspeed’s doctoral dissertation, a revised version of which is under consideration at Harvard University Press under the title Legislating Instability: Adam Smith, Free Banking, and the Financial Crisis of 1772.

[Cross-posted from]

Capital Unbound: The Cato Summit on Financial Regulation

Community chestInterested in how to advance economic growth? Join the Cato Institute’s Center for Monetary and Financial Alternatives in New York on June 2nd for a day examining the current state of U.S. capital markets regulation at Capital Unbound: The Cato Summit on Financial Regulation.

We’ve assembled an impressive list of distinguished speakers to discuss efficient capital markets and offer proposals to unleash a new engine of American economic growth.

Our lineup includes such notables as Commissioner of the U.S. Commodity Futures Trading Commission J. Christopher Giancarlo, Commissioner of the U.S. Securities and Exchange Commission Michael Piwowar, and our very own CMFA Director George Selgin.

The speakers will explore a wide variety of topics, including alternative vehicles for small business capital, the failure of mathematical modeling, and alternative solutions to monetary and financial instability.

Click here for the full schedule and to register for the event. We hope to see you in New York on June 2nd!

Hayek-Style Cybercurrency

In his groundbreaking work, Denationalisation of Money: the Argument Refined, F.A. Hayek proposed that open competition among private suppliers of irredeemable monies would favor the survival of those monies that earned a reputation for possessing a relatively stable purchasing power.

One of the main problems with Bitcoin has been its tremendous price instability: its volatility is about an order of magnitude greater than that of traditional financial assets, and this price instability is a serious deterrent to Bitcoin’s more widespread adoption as currency. So is there anything that can be done about this problem?

Yet Another Greek Secret: The Case of Phantom Assets

When banks are in distress, it is important to assess how easily the bank’s capital cushion can absorb potential losses from troubled assets. To do this, I performed an analysis using Texas Ratios for Greece’s four largest banks, which control 88% of total assets in the banking system.

We use a little known, but very useful formula to determine the health of the Big Four. It is called the Texas Ratio. It was used during the U.S. Savings and Loan Crisis, which was centered in Texas. The Texas Ratio is the book value of all non-performing assets divided by equity capital plus loan loss reserves. Only tangible equity capital is included in the denominator. Intangible capital — like goodwill — is excluded.

Despite the already worry-some numbers, the actual situation is far worse than even I had initially deduced. A deeper analysis of the numbers reveals that Greece’s largest banks include deferred tax assets as part of total equity in their financial statements. Deferred tax assets are created when banks are allowed to declare their losses at a later time, thereby reducing tax liabilities. This is problematic because these deferred tax assets are really just “phantom assets” in the sense that these credits cannot be used (read: worthless) if the Greek banks continue to operate at a pretax loss.

Contra Shiller: Stock P/E Ratio Depends on Bond Yields, Not Historical Averages

The Wall Street Journal just offered two articles in one day touting Robert Shiller’s cyclically adjusted price/earnings ratio (CAPE).  One of then, “Smart Moves in a Pricey Stock Market” by Jonathan Clements, concludes that, “U.S. shares arguably have been overpriced for much of the past 25 years.” Identical warnings keep appearing, year after year, despite being endlessly wrong.  

The Shiller CAPE assumes the P/E ratio must revert to some heroic 1881-2014 average of 16.6 (or, in Clements’ account, a 1946-1990 average of 15).  That assumption is completely inconsistent with the so-called “Fed model” observation that the inverted P/E ratio (the E/P ratio or earnings yield) normally tracks the 10 year bond yield surprisingly closely.  From 1970 to 2014, the average E/P ratio was 6.62 and the average 10-Year bond yield was 6.77.  

When I first introduced this “Fed Model” relationship to Wall Street consulting clients in “The Stock Market Like Bonds,” March 1991, I suggested bonds yields were about to fall because a falling E/P commonly preceded falling bond yields. And when the E/P turned up in 1993, bond yield obligingly jumped in 1994.

Since 2010, the E/P ratio has been unusually high relative to bond yields, which means the P/E ratio has been unusually low.  The gap between the earnings yield and bond yield rose from 2.8 percentage points in 2010 to a peak of 4.4 in 2012.  Recylcing my 1991 analysis, the wide 2012 gap suggested the stock market thought bond yields would rise, as they did –from 1.8% in in 2012 to 2.35% in 2013 and 2.54% in 2014.

On May 1, the trailing P/E ratio for the S&P 500 was 20.61, which translates into an E/P ratio of 4.85 (1 divided by 20.61). That is still high relative to a 10-year bond yield of 2.12%.   If the P/E fell to 15, as Shiller fans always predict, the E/P ratio would be 6.7 which would indeed get us close to the Shiller “buy” signal of 6.47 in 1990.  But the 10-year bond yield in 1990 was 8.4%.  And the P/E ratio was so depressed because Texas crude jumped from $16 in late June 1990 to nearly $40 after Iraq invaded Kuwait. Oil price spikes always end in recession, including 2008.

Today’s wide 2.7 point gap between the high E/P ratio and low bond yield will not be closed by shoving the P/E ratio back down to Mr. Shiller’s idyllic level of the 1990 recession.  It is far more likely that the gap will be narrowed by bond yields rising. 

None of the Fed’s Business

The latest Commerce Department report and FOMC press release have, as usual, led to a flood of commentary concerning the various economic indicators that the Fed committee must have mulled over in reaching its decision to put off somewhat longer its plan to start selling off assets it accumulated during the course of several rounds of Quantitative Easing.

Those indicators also inspire me to put in my own two cents concerning things that should, and things that should not, bear on the FOMC’s monetary policy decisions. My thoughts, I hasten to say, pay no heed to the Fed’s dual mandate, which is itself deeply flawed. But then again, since that mandate allows the FOMC all sorts of leeway in making its decisions, I doubt that it would prevent that body from following my advice, assuming it had the least desire to do so.

I have a simple–some may call it quaint–way of deciding whether some information supplies reason for the Fed to either sell off or buy more assets. Here it is: does the information offer reliable evidence of either a shortage or a surplus of nominal money balances?

More Proof of Math Gone Mad

Last September Kevin Dowd authored a dandy Policy Analysis called “Math Gone Mad: Regulatory Risk Modeling by the Federal Reserve.” In it Kevin pointed to the dangers inherent in the Federal Reserve’s “stress tests,” and the mathematical risk models on which those tests are often based, as devices for determining whether banks are holding enough capital or not.

Recently my Cato colleague Jeff Miron, who edits Cato’s Research Briefs in Economic Policy, alerted us to a new working paper, entitled “The Limits of Model-Based Regulation,” that independently reaches conclusions very similar to Kevin’s. The study, by Markus Behn, Rainer Haselmann, and Vikrant Vig, is summarized in this month’s Research Brief.

The authors conclude that, instead of limiting credit risk by linking bank capital more tightly to the riskiness of banks’ asset holdings, model-based regulation has actually increased credit risk. At the same time, because the model-based approach is relatively costly, large banks are much more likely to resort to it then smaller ones. Consequently, those banks have been able to expand their lending–and their risky lending especially–at the expense of their smaller rivals. In short, big banks gain, small banks lose, and we all are somewhat less safe than we might be otherwise.

Here is a link to the full working paper.

[Cross-posted from]