Making perfect sense

Robert Peston again - the government is now:

...excluding from the calculation of the risk premium payable to taxpayers the great surge in the perceived riskiness of banks that took place in September and October.

In effect, the Treasury has converted the Credit Guarantee Scheme from an insurance policy, which was designed to provide comfort to markets that banks wouldn't collapse for want of access to funding, into a new and substantial source of finance for banks, to replace the funds that have disappeared with the de facto closure of wholesale markets.

Well, kind of. There's a good argument that the banks are much less risky now - not least because they have been recapitalised by the taxpayer. This in turn justifies a lower premium.

Indeed, the most present risk to the banks was not that they would fundamentally become insolvent through writeoffs. It was that they would be unable to either refinance their short-term borrowings or call in their long-term loans. Securitisation used to allow them to sell the long-term loans if they needed money, but as Robert says that market is now closed.

But if the banks can get long-term borrowing from the government, this risk goes away. Once again that justifies a reduction in premiums.

Negatives of this:
  1. The short/long risk is transferred to the government - which in theory may have its own challenges in raising long-term debt. But in extremis, the government can print money to finance this - it should never have to default (the UK government is in the fortunate position of both borrowing and lending in pounds, at least for now).
  2. It creates an increase in the amount of short-term money available in the economy - wholesale lenders which would previously have lent to banks can now lend in the corporate or consumer markets instead. In theory this is a distortion to the normal structure of the money markets but with everything else that's happening, it just cancels out a distortion that's already happening.
And don't get the impression that the government is only displacing foreign lenders. Over 75% of debt owed by UK banks, companies and individuals is owed to others within the UK. About £309 billion is net foreign debt, but our foreign assets still make us more money than we pay out on the debt. Surprised?

Comments

Anonymous said…
Your comment and thrust assumes that the big UK banks are truly solvent, once the true write-downs of loans to commerce and industry and factored in.

I seriously doubt this is the case.
16 December 2008 at 10:08
Post a Comment

Popular posts from this blog

Is bad news for the Treasury good for the private sector?

An intriguing post from Robert Peston raising the spectre of the Treasury failing to sell all the bonds it wanted to sell yesterday. Is this, as he implies, plain bad news for the government because their funding is getting more expensive? Or is it good news for private lenders - implying that investors are fed up with their "flight to quality" and are now considering private sector investments instead? The answer is dependent on two further questions: is investors' money switching to foreign investments, UK private lending or UK equities? are investors actually running out of money to invest - the infamous savings trap, where people in aggregate try to increase their savings but fail to do so, because the attempt to save reduces total income in the economy and available savings are reduced too? Hopefully we can find out. How could we figure it out? by looking at total UK savings this month - this is not an exact science but we should hopefully be able to see if the tren
Read more

What is the difference between cognitive economics and behavioural finance?

This question was posed in an interesting LinkedIn discussion group (Behavioural Finance: Theory and Practice) by Kerry Pechter. I dashed off a quick answer which ended up being 500 words long. So I thought it might be useful to post on here. Can anyone tell me the difference between cognitive economics and behavioral finance? Cognitive economics is not yet a widely used phrase, though Marco Novarese and I have been using it as a name for a more microfounded version of what's typically called behavioural economics. So I'll answer the question based on how I use the term. The first difference is between "economics" and "finance". Economics is a broader field, including the trading of any kind of goods or services, whereas finance specifically focuses on investment and the value of financial instruments. Indeed I consider economics very broadly to be the study of how resources are allocated (by individuals, and across society). The more fundamental
Read more

Dead rats and dopamine - a new publication

My new paper, coauthored with Yohan John , Dakota McCoy and Oliver Braganza , is out in Behavioral and Brain Sciences. " Dead rats, dopamine, performance metrics and peacock tails " is about the universal emergence of proxy failure. When you measure and incentivise performance by a single metric (a proxy), the proxy will always become a worse measure of performance than it was before you added the incentive. This effect is also known as Goodhart's Law  in economics, and by other names in other fields - but the same underlying process drives the effect across multiple domains. Our paper studies it in management, economics, biology, neuroscience and other areas. Recent concerns about AI alignment are closely related to this phenomenon. The paperclip problem is a good example - if a sufficiently clever AI is given a single goal, to produce as many paperclips as possible, it may eventually destroy all of humanity and take over the whole universe in its efforts to maximise o
Read more