The Co-op Bank: how not to manage a crisis

It is always best to get all bad news out-of-the-way quickly and in one lump. Good news however is best allowed to seep out slowly and at regular intervals. Regular positive surprises create a feel-good environment which can become self-perpetuating. Regular negative surprises corrode trust and can lead to a collapse of confidence. This is certainly the case in banking.

The Co-op management appear to be providing business schools with a nice case study in confidence management within banking. At the start of the year the Co-op was going to buy a chunk of branches from Lloyds, encouraged by the government. However, by February it was public knowledge that it could not because its capital base was inadequate. The reaction in the price of its junior debt was remarkably muted until the bank was downgraded by several notches in May. The price then fell off a cliff and everyone became aware that the Co-op bank had problems. Quite why it took so long is a mystery. All this has been covered in detail in earlier blogs.

A rescue plan was constructed which involved bailing in the junior bond holders and a big capital injection from the Co-op group. The plan has been resisted by the junior bond holders even though junior debt exists, and is priced at issue, to perform precisely this function; capital buffer. As a result of this resistance, the Co-op has remained in the headlines as having ‘problems’ all through the summer. Trust has been corroding continuously.

Today, the Daily Telegraph publish a report (http://bit.ly/1fuYOtv) noting that the Co-op has ‘improved’ the method of valuing its loan book and now calculates the ‘fair value‘ of its loan book to be £3.6 billion less than it had thought.The ‘fair value’ is meant to reflect the market value of the loan book. It is compared to the book value minus any impairment adjustment and the revelation is that the fair value is £3.6 billion less than the book value less impairment adjustments. The implication is that further impairment charges will be made.The bank has indeed warned of further provision for bad debt.

Further bad debt provision implies further erosion in its capital base. It must either make up the capital erosion through retained earnings or raise more capital. It made a large loss in the first half of the year. It could bolster capital further by bailing in bond holders again. The corrosion of confidence continues and at some critical point it could become a (mathematical) catastrophe and result in an exodus of deposits.

The big issue of course is what would the government do? Would it effect a Northern Rock-like rescue of senior bond holders and uninsured depositors or would it seek to bail them in as happened in Cyprus to Laiki Bank and the Bank of Cyprus? From past behaviour, one would assume that the UK government would bail out the senior bond holders and uninsured depositors. However, all those junior bond holders would quite probably lose the rest of their value. Past behaviour is no guide to the future. The big question is does the Co-op represent a systemic risk and the answer may be that it does not.

The interests of all the stakeholders in the Co-op would be best served by a quick resolution to the Co-op problems and ceasing this constant drip of bad news.Otherwise the stakeholders may argue themselves into much more serious losses.

Cyprus Co-operatives: incompetence or fraud?

A confidential (huh?) Central Bank of Cyprus report has revealed the extent of the non-performing loans in the Cyprus Co-operative movement. One Co-op has reported 88% NPLs. High NPLs amongst many of the 93 Co-ops seems common. The government has nationalised the movement and re-organised it as 18 entities. The taxpayer will inject 1.5 billion euro into the new structure. The 1.5 billion will come from the assistance provided by the troika.

Several questions come to mind. With such high NPLs why has the Co-op movement not been subject to the same resolution as Laiki Bank and Bank of Cyprus? First, the amount of bonds and uninsured deposits was probably inadequate to cover the capital need. Second, the chances are the capital need exceeds the insured deposits as well. These are ultimately a liability of the state (i.e. taxpayer) so nationalisation and an injection of capital with taxpayer funds was probably necessary in any event. Thirdly, the political fall-out from a resolution of the Co-op movement would have been very severe. Finally, the troika did not demand it because the ECB was not into this sector via the ELA in the way it was to Laiki and they did not view the Co-ops as laundering money, at least not on the scale of the banks.

The big question is how a does a small Co-op end up with 88% of NPLs? This is quite an achievement, however performance is measured. Did no one notice that interest was not being paid or that the loan-to-value ratio was breaching the threshold? I assume that the Co-ops had LTV thresholds? Was there no supervision from the authority for the supervision of Co-operatives in Cyprus? Were the managers of the Co-op incompetent? Or, was something not entirely kosher going on here? Rather than hearing of large-scale investigations we are told that staff to be made redundant will receive pay-offs more generous than the bank staff. Huh?

The treatment of Cyprus by the troika has been harsh, much more so than other crisis states. It is not the justice issue that has bothered me but rather the impracticability of the treatment. It will crush the Cyprus economy and thus fail in its objective of returning the Republic to a sustainable debt path. However, the more that emerges, the less sympathetic to the Cypriots one is inclined. The evidence of nepotism, corruption, incompetence and sheer arrogance is becoming overwhelming. It is the Augean Stable of an already pretty smelly Europe. Perhaps the troika, confronted with a herculean task, has opted for a herculean response.

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Cyprus, The Bank of Cyprus and Banking Union

The Bank of Cyprus has finally emerged from resolution. For every 100k of uninsured deposits 47.5k will now be converted to equity. Quite how many shares this constitutes and how long this shareholding will take to once again be worth 47.5k remains to be seen. An additional 5k will be returned as cash, on top of the 10k already returned. The balance of 37.5k will be kept back as fixed term deposits, albeit at above market interest rates. The central bank reserves the option to roll over the deposits. In short, for every 100k of uninsured deposits, the depositors get 15k, some shares and some fixed term deposits which will accrue interest but cannot be spent until the central bank says . It could be worse but is hardly a matter for rejoicing.

The resolution gives Bank of Cyprus a Tier one capital ratio of 12%. This was, it seems, a matter of dispute because the memorandum of understanding only requires 9%. However, this 9%, it was explained to the hapless Cypriots, is a target tier one ratio for 2016. Evidently, the troika expect some further significant deterioration in the BoC loan book and have built-in a capital buffer. Good call. The 12% ratio is based on current data and one would not be wholly surprised to discover, over the fullness of time, that current data overestimate the quality of the loan book. The next step for BoC is to work through the non-performing loans and judging from the PIMCO report on Cyprus banks, the first step might be to correctly classify loans as non-performing or otherwise. We shall see.

The optimistic scenario is that the resolution will restore some faith in the Cyprus banking system and stop the slow haemorrhage of deposits. This would be a prelude to removing capital controls without all deposits instantly fleeing the system. However, the extent to which this scenario will unfold is very uncertain. Confidence in Cyprus banking is at a low ebb and the longer the controls remain the lower the confidence falls. It is Catch 22. In addition, the co-operative movement needs to be consolidated and this may further damage confidence. The exit of BoC from resolution is a good start but there is a treacherous road ahead.

The exit also does little for lending in the near term. The BoC must first tidy up its balance sheet and this will almost certainly involving shrinking. It cannot embark on new loans until it fully understands and provisions for the extent of non-performing loans. This may take a while. In the meantime, credit growth will be non-existent.

The pessimistic scenario is that the extent of non-performing loans quickly erodes the newly restored Tier one capital. The potential problems can all be discerned from the PIMCO report. Many loans were made against collateral or cross-guarantees. The value of the collateral and guarantees is being severely depressed by the present economic situation. If the banks try to resolve bad loans by foreclosure or charges against guarantors the result will be to depress the value of collateral further and boost bankruptcies. In the meantime, debt service will remain a challenge for borrowers and interest will accrue. Catch 22 again. The risk that the BoC will need another capital injection is non-zero.

This is the shape of banking union to come. A non-national body will determine the fate of banks that are unwise enough to make bad investments. The body will work its way through all the banks creditors, culminating in the uninsured depositors, in order to recapitalize the bank. If the bank is small relative to the economy in question this process may work out. However, if the bank is large then the knock-on effects to the economy may be quite devastating. The Bank of Cyprus and Laiki bank were huge relative to the Cyprus economy. This may not end well.

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The Co-op Bank: M101 Banking

The press coverage and comments around the Co-op rescue have been both surprising and annoying. The blog has started to look like M101 Banking so I may as well continue.

The Co-op capital shortage has been resolved. The press and their readers seem surprised it has been resolved without recourse to taxpayer money. No surprise at all. Taxpayer funds should only ever be involved in bank rescues if, and only if, there is systemic risk. This means if the bank failure in question could infect the system and trigger other banks to fail, causing a catastrophic cascade. This was never the case with the Co-op. It was the case with Lloyds Bank and RBS. In such cases taxpayers should welcome the intervention even if they have nothing in the bank. The reason is that, if the cascade is triggered, the consequences would most likely be a 1930s type depression and every taxpayer would suffer. The action of the UK government did not bail out bankers or their bonuses. The action bailed out the economy. The economy has suffered but not as much as it might have done.

Consider what would have happened if the banks had not been bailed out. RBS, Lloyds and various smaller banks would have ceased trading. The linkages would have meant that at least one other large bank (e.g. Barclays) would have also been brought to the brink of failure and may well have failed. The failures would have wiped out the shareholders, preference shareholders and junior bond holders ( e.g the Permanent Interest Bearing Shares and Perpetual Subordinated Bond holders).  However, it would not have stopped there. It would have damaged the senior bond holders and uninsured depositors, much like the haircuts experienced in Cyprus. Recall  that when the crisis started deposits were only insured below £50k. Finally, in 2008 the crisis was so severe that even the insured deposits were at risk and there is no way the FSCS, which is funded by a levy on banks, could have covered all insured bank deposits. The government would ultimately have picked up this bill in any event. Taxpayers and bank depositors alike should thank the government for its action. They should also look at the proposed banking union for the EU/eurozone and recognise that using taxpayer funds in this way may not be possible in the event of a systemic crisis. One should ask how the proposed banking union will deal with systemic crises. They do happen.

Returning to the Co-op, the resolution involves some capital contribution from the parent group and a bail in of the PSB holders. This is as expected and was discussed in my first blog (http://bit.ly/17T4CO6 ) on the subject of the Co-op. The PSB holders are complaining. Why? PSBs are junior debt and constitute part of the capital base of the mutual society. They are designed to facilitate liability management exercises such as this. Neither the capital nor the coupon on these instruments is guaranteed, the coupon is paid at the discretion of the mutual and, unless otherwise stated, is not cumulative. The instruments offer a better yield at issue because they are riskier than other instruments. The clue is in the higher than average yield at issue!

The real issues here were raised in the previous blog. Why was the Co-op pursuing expansion without adequate capital? Why was the government encouraging it to do so? Why did it take several months before the lack of capital, which became public information in February, was properly reflected in the price of PSBs? Why did it take a discontinous rating change to wake everyone up? This is what the press should be looking into. I should like to add why were PSBs held by any people who did not grasp the risk inherent in these instruments? Who advised them to do so? The clue is in the name; Perpetual Subordinated Bond. The degree of financial illiteracy in the population is staggering.

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The origins of the Eurozone Crisis and Banking Union

The origins of the eurozone crisis lie within the Maastricht Treaty. It connected a subset of EU states through a common monetary policy (EMU) and made no treaty provision for fiscal coordination. This lack was papered over by the Stability and Growth pact (http://bit.ly/199QLRy), which took its legal authority from the Treaty on the Functioning of the European Union (TFEU).

The markets were at first sceptical of the EMU project but later warmed to it and priced eurozone sovereign debt as if it was guaranteed by some overarching EU body. It took the debt crisis in Greece to explain to the markets that it was not so guaranteed. Worse still, it became apparent that the Maastricht treaty precluded the possibility of a collective EU institution providing assistance to debt-ridden sovereign states within the eurozone. The crisis management mechanisms have so far been constructed as bilateral commitments from member states. No single eurozone member is liable for all other eurozone member state liabilities.  Individual commitments to crisis management mechanisms such as the EFSF and ESM are limited by design.

The only institution that is genuinely a collective eurozone entity is the ECB. This is why ECB action under the crisis has been so closely scrutinised by the German Constitutional Court. The Court has been at pains to make sure that the ECB did not act in a way that implied a collective bail-out of the debt-ridden states. The ECB has been quite creative in this respect and has provided considerable collective assistance under the guise of monetary policy and of repairing the monetary transmission mechanism. The Outright Monetary Transactions (OMT) programme has been a particularly effective innovation.

The objective of Berlin has been to avoid the crisis becoming an excuse to move from bilateral action to official collective action by EU institutions. Collective actions would make, implicitly or otherwise, each member state jointly and severally liable for other member states. If a collective framework emerged then eurozone sovereign debt would become mutual and the liability of all eurozone states. This is what the markets originally thought was happening which is why they allowed countries such as Greece to borrow excessive amounts at very low-interest rates. Such mutualisation carries with it the risk of moral hazard and the behaviour of many member states in the early years of EMU suggests that moral hazard is a very real issue for the eurozone.

Germany, as the wealthiest member state, took control of the crisis (excluding France) and made avoiding moral hazard its main target. Hence all responses have been structured as bilateral arrangements. This is not to say that Berlin will not ever countenance a collective structure. However, it will not do so until it believes it has put into place safeguards against moral hazard.

The main innovation from Berlin is the  Treaty on Stability, Coordination and Governance in the Economic and Monetary Union or the Fiscal compact for short. This is an international intergovernmental Treaty and outside of the EU legal framework. It nevertheless binds those ratifying to a Berlin-approved fiscal framework and ratification is a pre-condition for access to some bilateral eurozone arrangements (like the ESM). The intention is to incorporate this treaty into the EU legal framework but of course that will require the unanimous agreement of all EU states.

The existence of the fiscal pact reveals a fundamental problem in the EU. There is a subset of member states, the eurozone, with different needs. The EU legal framework is set up for all member states, including non-eurozone. To resolve this requires some significant treaty change and treaty change must be unanimous. This is a politically complex situation and lies behind the clumsy and cumbersome manner in which the crisis has been handled.

The same problem is now evident in the debate on banking union. The union requires a single supervisory mechanism (SSM) for banks. All banks in the union should be bound by the same rules and be supervised by the same entity. Troubled banks must be resolved in exactly the same manner by this authority so there is a need for a single resolution mechanism (SRM). Finally, there needs to be a central fund to finance these actions, namely a single resolution fund (SRF). All three must operate above sovereign states and the single supervisory authority must be able to intervene in member states independently of the views of the government of that state.

Such an arrangement effectively mutualises banking risk across member states. It raises a lot of questions. Will individual member states be willing to give up supervisory control of their own banking systems? Indeed in this framework there are no national banking systems, only EU-wide. The second question is the source of the SRF. The plan is for a levy on banks in the same manner as say the FSCS. Such a levy is sufficient for individual bank problems but what happens if a systemic crisis arises? Will an EU-wide body act to avoid systemic failure in the way the UK government used tax payers money to save the UK system? If so is this not a form of sovereign debt mutualisation? Finally, there is the nature of bank resolution. The Cyprus crisis revealed that the prospective banking union will place senior bond holders and uninsured depositors explicitly at risk in the SRM. They have always been implicitly at risk (that is why the deposits are called uninsured) but it has been rare to bail-in uninsured depositors in the manner we have seen in Cyprus. It will no longer be rare. This may have important implications for financial centres such as the City of London.

The important point however is that this total framework cannot reasonably be expected to operate on an intergovernmental basis. The SSM has been advanced within the Treaty of Lisbon. However, the SRM and SRF may prove more problematic.These steps may require changes to the Treaty of Lisbon. Good luck with that. The likely result will be that banking union may be less smooth in its manifestation than many seem to assume. It essentially mirrors the fiscal union issue and it is unlikely that one can be resolved without the other.

My own personal view, for what it is worth, is that the EU project has reached its day of reckoning. An EU consisting of euro zone and non-eurozone is no longer possible. The direction is now for EU institutions to evolve to serve the eurozone and for non-eurozone states to be marginalised. The eurozone structure will also become ever more integrated and reflect a fiscal framework that is a direct copy of that of Germany. Mutualisation may eventually occur but not before all members have legally enforceable budget constraints built into their constitutions. Talk of repatriation of powers by the UK is so much subterfuge. The UK faces a straight in or out choice. Moreover, ‘in’ now means joining the euro.

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Cyprus property prices: an example of market failure

The Cyprus property market appears to have ground to a halt. In trying to update on the situation it is natural to start with Royal Institute of Chartered Surveyors for Cyprus (http://bit.ly/19U6HbR). The last RICS index publication appears to have been for Q4 2012. It may also come as a surprise to discover that prices have been steadily falling since 2009 (see Chart above courtesy of RICS Cyprus). How much further will they fall?

The simple answer is that no one knows but it is likely to be a lot more. The first problem is the banks. They will not be expanding their loan books for a while. In part this has to do with capital requirements but, as in many european countries, it also reflects a correct assessment of the present risk in lending. Unemployment in Cyprus is already high and is rising fast. Unemployment will not peak for some time. Wages are falling. Normal credit processes would preclude an expansion in lending under such circumstances.

In the meantime they must work out their bad loans. The PIMCO report (http://bit.ly/11om1c4) provides a graphic account of past bad lending practices that has led to the accumulation of bad loans.The loans were made on the basis of cross-collateral and co-guarantees rather than any credit assessment of the borrowers capacity to service the loan. Unpaid interest was added to the loan and booked as income. As long as the value of collateral grew at least as fast as the accumulated interest all was deemed satisfactory. Until now, when the value of the collateral is at best indeterminate but almost certainly less than the outstanding loan. The workout of these loans is the job of the ‘bad banks’ that have been set up. If they try to realise the collateral, property prices will collapse in front of the sale. If they try to collect from the co-guarantors, bankruptcy figures will rise even faster. Their only option is to take possession and let the properties (most probably to the borrower). These banks will, by default (no pun intended), become property management companies. It will take a long time to workout these bad loans in this way. In the meantime loan provisions will erode earnings and capital. This will also be true of the good banks, as more loans go bad. The banking crises is not over yet.

What about foreign investors? This category was in part responsible for driving up prices and facilitating this giant Ponzi scheme. Even if the tiresome issue of title deeds is resolved, many may not return for a while. There are many question marks for the foreign investor. When will prices bottom? When will Cyprus banks be safe? Will Cyprus survive in the eurozone or even EU? It is unlikely that foreign investment will help Cyprus property before prices have fallen far enough to justify the remaining risks.

The first likely outcome is that volume of sales will dry up. This is bad news for estate agents and property valuation companies. It is also bad news for government that earns revenue from property transactions. Of course, the government can make this up via the new property taxes. So the investor that avoided the banking crisis by investing all in ‘immovable’ property now faces taxes on property that cannot be sold except at much less than was previously thought (if at all). Selling immovable property in Cyprus was never popular because of the high capital gain taxes imposed. This is much less of an issue now and going forward I imagine!

Cyprus property has experienced a market failure, a concept introduced in earlier blogs on Abeconomics. It is simply not functioning and it may well take some time before full functionality, or what passes for functionality in Cyprus, is restored. In the meantime property prices are indeterminate, which will make the job of constructing indices rather tricky. If the indices are based on actual sales prices there may be insufficient sales to be meaningful. If the indices are based on asking prices they may seriously overestimate the true market. The logical thing for an individual to do is wait but of course this just makes the macro situation worse.

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UK banking and the Co-op bank: what is going on?

Early in May Moody’s downgraded Co-op bank by six notches from investment grade to junk. Now that is a discontinuity. Something new must have been discovered and it was not good. The new discovery was a large hole where the bank’s capital should have been. It came to light during the Co-op’s planned acquisition of a chunk ( 632) of Lloyd’s bank branches (and attached customers). Except that it was not new, at least not in May.

The capital shortfall and the consequent impossibility of consummating the Lloyds bank branch purchase was flagged in the FT on February 26, 2013 (http://on.ft.com/ZAfptJ). The subsequent downgrade by Moody’s was reported in the FT on May 10, 2013 (http://on.ft.com/12mYzAo). Why did it take so long to implement the downgrade? More important, why were Co-op bank management pursuing such an aggressive expansion without appropriate capital resources? Even more important, why were the government so supportive of the purchase, and dismayed at its demise ( http://on.ft.com/10ONL7A), given the inadequate capitalisation of Co-op bank? Do they want another bank failure?

The source of the capital problem seems to date back to the acquisition of the Britannia building society ,and its less than healthy mortgage book, in 2009. Does this sound familiar? A very good analysis of the nitty-gritty of the Co-op bank case is provided on an ongoing basis by Mark Taber on (http://bit.ly/15mY7PZ) and which I recommend all read. The upshot is that subordinated debt seems capable of absorbing the capital short fall so senior bond holders and uninsured depositors are not at any serious risk. Moreover, the internal resources of the Co-op group may be able to help fill the capital short-fall so even the subordinated debt could remain unscathed. Nevertheless the Co-op bank remains at junk rating and the above questions remain unanswered.

The Co-op bank has since halted new corporate business. It is deleveraging. It is also experiencing some high-profile loss of local council business (http://on.ft.com/11dELbW). It is never good when a bank appears in the news with negative headlines on a regular basis. It is never good when a bank’s debt is rated junk status. It is never good when there is any uncertainty or confusion surrounding the condition of a bank.

The Co-op bank situation has arisen in isolation and does not pose any systemic risk. It is probable that it will succeed in raising capital without a bail in of subordinated bond holders. However, it is not a certainty and the rating suggests it is a material risk. Are senior bond holders and uninsured depositors at risk? Not on the basis of the existing data. Nor indeed on the basis of past practice in the UK ( see previous blogs on banking). However, if you have uninsured exposure to the Co-op bank it is wise to monitor developments. For the vast majority of the population this is impractical and, as a rule, by the time new information gets to them it is usually too late. This was certainly the case for those holding Co-op Perpetual Subordinated Bonds and preference shares.The above chart is of the Co-op 13% Perpetual Subordinated Bond, courtesy of the London Stock Exchange. The information flow to the common man is well illustrated. On February 26, 2013, the price stood at 167.2. On May 9, 2013, it was still trading at 153.5. On May 10 it fell to 105.5 before bottoming at 83.5 on May 14. On May 31, 2013, it stood at 91.5. The capital black hole was public information on February 26 but the significance of this was not priced in until May 10. Food for thought for the complacent.

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Bank lending, FLS and SMEs: Harold Wilson is back

English: Lord Harold Wilson portrait (Photo credit: Wikipedia)

Central banks have flooded financial systems with ‘central bank’ money since the crisis of 2008. However, the growth of various measures of money supply, which include deposits at banks, have barely grown. The reason is partly to do with the need for broken banks to raise capital to permit balance sheet growth and a greater caution in bank lending owing to an uncertain economic outlook. The banks, having been badly beaten up by politicians, the media and the public, have not unnaturally become a little extra cautious.

The UK government tried to offset this natural reticence by introducing the Funding for Lending Scheme (FLS) via the Bank of England (http://bit.ly/12NL6en). The FLS liquefies bank balance sheets at low-cost and enables further lending at a lower cost than otherwise. This  scheme makes sense only if the problem for banks was the availability and cost of funds. Given the unspectacular success of the scheme one must assume this was not the case. Indeed one suspects it merely raised bank profitability on lending they would have carried out in any event.

Banks lost a lot of capital in the financial crisis and raising new capital has been expensive and challenging for some. Lending standards have also been raised. This is the logical response to all the criticism. The best banking model bases lending on the likelihood of being repaid. Collateral is helpful to limit loses in default but recovering a defaulted loan is an expensive business however well secured and, of course, the value of the collateral is itself variable. If the problem is system-wide then recovery can be problematic indeed. For a case study of this see the PIMCO report on Cyprus banking which can be accessed via my blog PIMCO report on Cyprus banking system: obsolete. Cyprus banks habitually made loans with little regard to likelihood of repayment, it seems, and relied heavily on cross-collateral and co-guarantors. This did not end well.

Banks are now being criticised for not lending enough to small and medium enterprises or SMEs. Vince Cable is particularly vociferous in this respect. Indeed Mr Cable is now lending tax payer money directly to SMEs via a new government business bank (http://bit.ly/140iNfa). What is unclear is what criteria this business bank is using to make such loans as the motivation seems to have been the failure of banks to meet this demand.  If banks felt SME lending was too risky and/or SMEs have been reluctant to borrow, why will this business bank change matters? The implication is of course that business bank loans are an implicit subsidy to the SME sector from the tax payer. The last time I recall this type of government polciy was under Harold Wilson. I do not think Margaret Thatcher would have approved. Who will take the blame for losses arising to the tax payer from business bank loans? One of the unfortunate side effects of the FLS and business bank initiatives has been to depress rates available to savers. Savers are also tax payers. So tax payer funds are being channelled to SMEs and depressing savings rates for these same tax payers.

I have some direct experience of the riskiness of lending to SMEs. I have loaned  a small amount to SMEs via a peer-to-peer lender. The loans are typically secured or guaranteed. My income for the last tax year is £256.25. My loss from bad debt is £164.19. Judging by the high number of comments on outstanding loans,  I will incur further loan losses in this tax year. Of course, there may be recoveries as well. However, these take time and are highly uncertain and expensive. I will of course be taxed on the income and cannot offset the losses against my income tax. My losses may reflect my investment choice of loans and diversification strategy. However, I doubt it. I have also loaned money to individuals via other peer-to-peer websites and have only had £10 written off since inception. Indeed young people under the age of 25 have impressed me as very reliable. However, this is all anecdotal and ony for illustration. The important point is that SMEs can and do default.

The business bank has also started to lend via this peer-to-peer lender. This has depressed interest rates further along with the general impact of FLS. The returns available  from reinvestment are now much lower from my SME pool. Given the tax disadvantage, the lower rates and my experienced default rate, I am running my portfolio down and reinvesting in unsecured peer-to-peer personal loans. The net effect of the business bank has been to displace my small loan. Mine may not be the only loan displaced. Moreover, there is no reason to think the business bank will have a different bad debt experience. The money the business bank is lending is that of the tax payer and I am a tax payer. Nice job Vince.

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Slovenia is not Cyprus!

Slovenia is not Cyprus. At least it was not until the Cyprus bail-in took place. Now every member state in the eurozone is potentially like Cyprus. It rather depends on which decision model one believes operates; probability or uncertainty.

A selection of Normal Distribution Probability Density Functions (PDFs). Both the mean, μ, and variance, σ², are varied. The key is given on the graph. (Photo credit: Wikipedia)

In the probability model all risks are known and quantifiable. This model predicts that Slovenia is unlikely to have a sovereign debt crisis or banking crisis or need assistance from the ESM. Or so some assert. A notable exception is Moody’s, the rating agency, which has downgraded  Slovenia as a borrower from Baa2 to Ba1 and put the eurozone member state on negative watch. In other words, any other rating change is likely to be another down grade. Even in the probability model there is room for different probability assessments; a little uncertainty.

In the uncertainty model (or the real world as I like to call it) anyone exposed to Slovenia sovereign debt or banking must be having a hard think here. Slovenia is constantly in the media with talk of financial problems and Moody’s, which knows a thing or two about quantifying risk, calculates that the situation is drifting in the wrong direction. The inhabitants of the uncertainty world cannot calculate probabilities and have a sneaking suspicion that they have imperfect knowledge of the risks. Moreover, the constant assertion that Slovenia is not Cyprus is beginning to make many a little uneasy. The lady doth protest too much, methinks.

A Slovenian with a bank deposit above euro 100k may be forgiven for looking at Cyprus and wondering how much of special case it is. The European Banking Union is not yet in place but the prospect of including bank bail-ins is almost certain. This same Slovenian has the option of placing any excess euro funds with a bank in another member state. This is not a costless exercise but it is possible because, well, it is a monetary union!

Of course, if all Slovenians suddenly shifted uninsured funds to non-Slovenian jurisdictions then the much feared bank failure could be precipitated. The Emergency Liquidity Assistance from the ECB to Slovenian banks would suddenly jump. Moreover, ironically, in any consequent bank resolution there would not be any uninsured deposits to bail-in. The ESM would need to provide all bank recapitalisation.

An individual Slovenian with imperfect knowledge of the risks and the Cyprus example to hand might quite rationally shift uninsured funds out of Slovenia and into neighbouring jurisdictions even if she/he judged the risk of crisis to be low. The reason is that the consequences of a bail-in would be severe and it is possible, for a price, to avoid the risk. What is rational for an individual is not rational for all (often the case) as, if everyone does this, the probability of a banking crisis increases. Nevertheless, rational individuals operating under the uncertainty model might well take such risk aversive action and the reason is precisely because the Cyprus bail-in took place. The troika made Slovenia, and potentially all member states, a little more like Cyprus by their actions. They set a precedent, of which rational individuals will have taken note.

I know nothing of the specific situation of Slovenia as a sovereign or its banking system. These comments are not based on a probability assessment. These comments are merely an illustration of a how a rational individual might act to avoid a seriously adverse outcome even if he/she is reassured that the probability of the outcome is very small. It is an illustration of rational behaviour under uncertainty. It applies to measles and global warming as well as finance.

To complete the illustration please re-read (or read) my earlier blog; Cyprus bail-in; a surprise?. In this blog I demonstrate that there was a great deal of public information to warn depositors in Cypriot banks that a bail-in was a material risk. Some heeded the warning as is evidenced by deposit outflows. However, rather more did not heed the warning otherwise there would have been nothing to bail-in. The reason they did not heed the warning is because there was no precedent.

The good news for Slovenia is that it is unlikely the troika would be foolish enough to allow any further bank bail-ins prior to a fully fledged banking union being in place. Imagine what would happen if Slovenian banks were bailed-in at the expense of uninsured depositors. Under the uncertainty model any uninsured deposits in any suspect banking jurisdiction would suffer a major deposit outflow. Then where would the eurozone be.? So ultimately keeping uninsured deposits in the Slovenian banking system is an act of faith in the good sense of the troika.

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Bitcoin, Gold and Private Money

The bitcoin logo (Photo credit: Wikipedia)

The only characteristic that a private money need have is that it is accepted as a medium of exchange. The more widely it is accepted, the more successful it is as a private money. The usual list of attributes of money that one will find in economics text books are those that contribute to its acceptability as a medium of exchange.

Bitcoin is a very efficient form of private money for the digital age. It is divisible, durable and costs very little to store. It is highly mobile geographically and requires no third-party intermediation. it is ideal for peer-to-peer transactions. It is the cash of cyberspace. It is possible to steal, though forgery may be more challenging. Like cash, Bitcoin is ideal currency for unregulated or, colloquially, black market, transactions. It is this electronic cash-like characteristic that has most likely been behind the success of Bitcoin. The progress and use of Bitcoin will for this reason be closely monitored by authorities worldwide.

Bitcoin is private cash and is produced privately. The seigniorage, or gain from simply producing and providing the cash, accrues to private producers. The seigniorage accrues to the miners. The total production and rate of production is controlled. This is important and understanding how it is controlled is vital to the continued acceptability as a form of money.

A key issue is the function as a store of value. The value of fiat money fluctuates with the rate of general price inflation. Bitcoin has a currency value, typically quoted in US dollar. There is no need to use Bitcoin as a store of value. One can always buy at the prevailing rate of exchange (at least in principle). However, this rate of exchange may not be stable. For those using Bitcoin to transact regularly holding some Bitcoin as liquidity will be attractive. If Bitcoin is successful more and more liquidity balances will build and during this process the exchange value of Bitcoin may increase. This may well have been the experience to date.

Of course, as with any commodity it is subject to speculative excess. Wide variations in exchange value over short periods will undermine the attractiveness of the Bitcoin as a form of liquidity. This however is inevitable in the early stages as liquidity balances build. The success of Bitcoin as money can be measured through the volume of use in transactions and average size of liquidity balances. However, data may not be easily available.

Bitcoin is often compared to gold as a private money. However, the comparison is anachronistic. Gold is not used as a medium of exchange. It is used as a store of wealth. Gold is expensive to store, transport and secure. It is not easily divisible. It is a poor alternative to Bitcoin as money. It may however be a better store of value. It has a well-developed derivatives market where physical gold can be hedged in large size.

The gold price dropped precipitously recently triggered by the prospect of gold sales by the Republic of Cyprus [ see my blog Gold, Oil and Bitcoin]. It has since recovered some ground. However, the prospects for the gold price longer term may not be good. Financial anxiety is diminishing and this may see further price falls. There are alternative asset classes that offer better vehicles for storing value.

The demand for a private medium of exchange however may be growing. The internet has been successful at piercing national boundaries and regulatory frameworks. National authorities will work ever harder to keep the internet within the official regulated sector. However, arbitraging regulations and boundaries seems to be a popular human activity and was/is one important driving force in the investment banking sphere. It is likely to continue to be so in cyberspace. Private money will facilitate the arbitrageurs and black marketeers and thus is likely to be in great demand.

This is an interesting development to monitor from a distance.

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