Tuesday, April 30, 2013

Don't Touch the Yield

There's a widespread idea in finance and economics land that there's something wrong, dangerous, even unnatural about persistently low interest rates.

This idea takes its perhaps most reasonable form in arguments that the fundamental cause of the Great Financial Crisis was rates that were "far too low for far too long," and that continued low interest rates, going forward, will only encourage speculation and new asset bubbles. Behind, or anyway alongside, these kinds of claims is a more fundamentally ideological view, that owners of financial assets are morally entitled to their accustomed returns, and woe betide the society or central banker that deprives them of the fruit of their non-labor. You hear this when certain well-known economists describe low rates as the "rape and plunder" of bondowners, or when Jim Grant says that the real victims of the recession are investors in money-market funds.

I want to look today at the "reaching for yield" version of this argument, which Brad Delong flagged as PRIORITY #1 RED FLAG OMEGA for the econosphere after it was endorsed by the Federal Reserve's Jeremy Stein. [1] In DeLong's summary:
Bankers want profits. ... And a bank has costs above and beyond the returns on its portfolio. For each dollar of deposits it collects, a bank must spend 2.5 cents per year servicing those deposits. In normal times, when interest rates are well above 2.5 percent per year, banks have a normal, sensible attitude to risk and return. They will accept greater risk only if they come with returns higher enough to actually diminish the chances of reporting a loss. But when interest rates fall low enough that even the most sensible portfolio cannot reliably deliver a return on the portfolio high enough to cover the 2.5 cent per year cost of managing deposits, a bank will "reach for yield" and start writing correlated unhedged out-of-the-money puts so that it covers its 2.5 percent per year hurdle unless its little world blows up. Banks stop reducing their risk as falling returns mean that diversification and margin can no longer be counted on to manage them but instead embrace risks. 
It is Stein's judgment that right now whatever benefits are being provided to employment and production by the Federal Reserve's super-sub-normal interest rate policy and aggressive quantitative easing are outweighed by the risks being run by banks that are reaching for yield. 
Now on one level, this just seems like a non-sequitur. "Banks holding more risky assets" is, after all, just another way of saying "banks making more loans." In fact, it's hard to see how monetary policy is ever supposed to work if we rule out the possibility of shifting banks' demand for risky private assets. [1] An Austrian, I suppose, might follow this logic to its conclusion and reject the idea of monetary policy in general; but presumably not an Obama appointee to the Fed.

But there's an even more fundamental problem, not only with the argument here but with the broader idea -- shared even by people who should know better -- that low interest rates hurt bank profits. It's natural to think that banks receive interest payments, so lower interest means less money for the bankers. But that is wrong.

Banks are the biggest borrowers as well as the biggest lenders in the economy, so what matters is not the absolute level of interest rates, but the spread -- the difference between the rate at which banks borrow and the rate at which they lend. A bank covers its costs as reliably borrowing at 1 percent and lending at 4, as it does borrowing at 3 percent and lending at 6. So if we want to argue that monetary policy affects the profitability of bank lending, we have to argue that it has a differential effect on banks funding costs and lending rates.

For many people making the low-rates-are-bad-for-banks argument, this differential effect may come from a mental model in which the main bank liabilities are non-interest-bearing deposits. Look at the DeLong quote again -- in the world it's describing, banks pay a fixed rate on their liabilities. And at one point that is what the real world looked like too.

In 1960, non-interest-bearing deposits made up over two-thirds of total bank liabilities. In a system like that, it's natural to see the effect of monetary policy as mainly on the asset side of bank balance sheets. But today's bank balance sheets look very different: commercial banks now pay interest on around 80 percent of their liabilities. So it's much less clear, a priori, why policy changes should affect banks interest income more than their funding costs. Since banks borrow short and lend long (that's sort of what it means to be a bank), and since monetary policy has its strongest effects at shorter maturities, one might even expect the effect on spreads to go the other way.

And in fact, when we look at the data, that is what we see.

Average interest rate paid (red) and received (blue) by commercial banks. Source: FDIC

The black line with diamonds is the Federal Funds rate, set by monetary policy. The blue line is the average interest rate charged by commercial banks on all loans and leases; the solid red line is their average funding cost; and the dotted red line is the average interest rate on commercial banks' interest-bearing liabilities. [3] As the figure shows, in the 1950s and '60s changes in the federal funds rate didn't move banks' funding costs at all, while they did have some effect on loan rates; the reach-for-yield story might have made sense then. But in recent decades, as banks' pool of cheap deposit funding has dried up, bank funding costs have become increasingly sensitive to the policy rate.

Looking at the most recent cycle, the decline in the Fed Funds rate from around 5 percent in 2006-2007 to the zero of today has been associated with a 2.5 point fall in bank funding costs but only a 1.5 point fall in bank lending rates -- in other words, a one point increase in spreads. The same relationship, though weaker, is present in the previous two cycles, but not before. More generally, the correlation of changes in the federal funds rate and changes in bank spreads is 0.49 for 1955-1980, but negative 0.38 for the years 1991-2001. So Stein's argument fails at the first step. If low bank margins are the problem, then "super-sub-normal interest rate policy" is the solution.

Let's walk through this again. The thing that banks care about is the difference between what it costs them to borrow, and what they can charge to lend. Wider spreads mean lending is more profitable, narrower spreads mean it's less so. And if banks need a minimum return on their lending -- to cover fixed costs, or to pay executives expected bonuses or whatever -- then when spreads get too narrow, banks may be tempted to take underprice risk. That's "reaching for yield." So turning to the figure, the spread is the space between the solid red line and the solid blue one. As we can see, in the 1950s and '60s, when banks funded themselves mostly with deposits, the red line -- their borrowing costs -- doesn't move at all with the federal funds rate. So for instance the sharp tightening at the end of the 1960s raises average bank lending rates by several points, but doesn't move bank borrowing rates at all. So in that period, a high federal funds rate means wide bank spreads, and a low federal funds rate means narrower spreads. In that context the "reaching for yield" story has a certain logic (which is not to say it would be true, or important.) But since the 1980s, the red line -- bank funding costs -- has become much more responsive to the federal funds rate, so this relationship between monetary policy and bank spreads no longer exists. If anything, as I said, the correlation runs in the opposite direction.

Short version: When banks are funded by non-interest bearing deposits, low interest rates can hurt their profits, which makes them have a sad face. But when banks pay interest on almost all their liabilities, as today, low rates make them have a happy face. [4] In which case there's no reason for them to reach for yield.

Now, it is true that the Fed has also intervened directly in the long end, where one might expect the impact on bank lending rates to be stronger. This is specifically the focus of a speech by Stein last October, where he explicitly said that if the policy rate were currently 3 percent he would have no objection to lowering it, but that he was more worried about unconventional policy to directly target long rates. [5] He offers a number of reasons why a fall in long rates due an expectation of lower short rates in the future would be expansionary, but a fall in long rates due to a lower term premium might not be. Frankly I find all these explanations ad-hoc and hand-wavey. But the key point for present purposes is that unconventional policy does not involve the central bank setting some kind of regulatory ceiling on long rates; rather, it involves lowering long rates via voluntary transactions with lenders. The way the Fed lowers rates on long bonds is by raising their price; the way it raises their price is by buying them. It is true, simply as a matter of logic, that the only way that QE can lower the market rate on a loan from, say, 4 percent to 3.9 percent, is by buying up enough loans (or rather, assets that are substitutes for loans) that the marginal lender now values a 3.9 percent loan the same as the marginal lender valued a 4 percent loan before. If a lender who previously would have considered a loan at 4 percent just worth making, does not now consider a loan at 3.9 percent worth making, then the interest rate on loans will not fall. Despite what John Taylor imagines, the Fed does not reduce interest rates by imposing a ceiling by fiat. So the statement, "if the Fed lowers long rates, bank won't want to lend" is incoherent: the only way the Fed can lower long rates is by making banks want to lend more.

Stein's argument is, to be honest, a bit puzzling. If it were true that banks respond to lower rates not by reducing lending or accepting lower profit margins, but by redoubling their efforts to fraudulently inflate returns, that would seem to be an argument for radically reforming the bank industry, or at least sending a bunch of bankers to jail. Stein, weirdly, wants it to be an argument for keeping rates perpetually high. But we don't even need to have that conversation. Because what matters to banks is not the absolute level of rates, but the spread between their borrowing rate and their lending rate. And in the current institutional setting, expansionary policy implies higher spreads. Nobody needs to be reaching for yield.


[1] The DeLong post doesn't give a link, but I think he's responding to this February 7 speech.

[2] As Daniel Davies puts it in comments to the DeLong post:
If the Federal Reserve sets out on a policy of lowering interest rates in order to encourage banks to make loans to the real economy, it is a bit weird for someone's main critique of the policy to be that it is encouraging banks to make loans. If Jeremy Stein worked for McDonalds, he would be warning that their latest ad campaign carried a risk that it might increase sales of delicious hamburgers.
[3] Specifically, these are commercial banks' total interest payments from loans and leases divided by the total stock of loans and leases, and total interest payments divided by total liabilities and interest-bearing liabilities respectively.

[4] Why yes, I have been hanging around with a toddler lately. 

[5] Interesting historical aside: Keynes' conclusion in the 1930s that central bank intereventions could not restore full employment and that fiscal policy was therefore necessary, was not -- pace the postwar Keynesian mainstream -- based on any skepticism about the responsiveness of economic activity to interest rates in principle. It was, rather, based on his long-standing doubts about the reliability of the link from short rates to long rates, plus a new conviction that central banks would be politically unable or unwilling to target long rates directly.


17 comments:

  1. Effectively a lot of deposits are "non interest bearing" in the 0%-1% range. That's because deposit rates bottom out at 0%.

    So while "low" rates don't hurt profits, close to 0% rates do hurt. The biggest complainers are money market funds (which are banks, though with a different regulatory structure than "real" banks), because deposits are their only business.

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    1. Yeah, no sale.

      First of all, what I am looking at is the average interest rate on all bank loans, on all bank liabilities, and on interest-bearing bank liabilities. And it is just a fact that over the past two decades, the average interest rate on bank borrowing is more tightly correlated with the Fed Funds rate than the average interest rate on bank lending is.

      It should be possible to do the same exercise for the financial sector as a whole. I don't have time now, but hopefully will in the next couple of weeks and will report the results here when and if.

      But I'm pretty sure it is not going to be the case that MMMFs have lower spreads when rates are low -- their deposit rates are very tightly linked to the policy rate -- more tightly than the commercial paper they buy. Their problems are different.

      If you want a better version of this, look at pension funds and insurance companies, whose liabilities are really fixed. But I don't think that's what this is really about either. I think the real "victims" here are the ultimate owners of financial wealth.

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    2. http://www.ici.org/pdf/per19-03.pdf

      Refer to figure 11 on page 11. From 2008-2012 money market funds lost at least $12 billion of profits due to near-zero rates.

      Again, my point is not about "low" rates but about close to 0% rates. It would only take a small rate increase to restore almost all the profit.

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    3. http://research.stlouisfed.org/fred2/graph/?g=isL

      MZM is not that tightly coupled.

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    4. rsj, I didn't realize that the "normal" bank deposit spread was so large (2-3%).

      So rates need to rise quite a bit to restore the traditional profitability of bank deposits.

      (This shouldn't be confused with the profitability of loans, which is a different issue and I assume more important to overall bank profitability).

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    5. A fall in the Fed Funds rate reduces the profitability of deposit-taking, and increases the profitability of lending, with the strength of both effects depending on how tightly linked the relevant market rates are to the Federal Funds rate.

      In the 1950s-1970s, the former effect dominated, and low rates lowered bank profits. Since the 1980s, the latter effect has dominated, and low rates increase bank profits.

      Right?

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    6. In the 1950s-1970s, deposit rates were regulated, so they were completely decoupled. Now, they are coupled, but not so tightly as to be ignored.

      But it is true that a sharp hike in rates will cause many borrowers to be unable to roll over loans and default, hurting bank profitability, while a decline will tend to reduce defaults. The canonical example would be Volcker's hikes and the subsequent latin american debt crisis.

      But, that is not a trade off because one factor is the level of rates while the other is the rate of change. We can say that the best environment for banks are high rates that are decreasing, and the worst environment would be low rates that are going up.

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  2. some assorted thoughts:

    are some traders (and others characters) at banks paid not on the basis of the spread, but in some sense on the gross return they generate? This arrangement might make sort of sense if bank managers think "the cost of funding is what it is, now I want my traders to go out and max their returns"

    I suppose actors such as pension funds, hedge funds etc. are going to search for yield, as they always do. Is there anything more dangerous, w.r.t financial stability, about their behaviour when yields are low?

    Have you looked at this "negative carry" argument, put forward by FT Alphaville, that threatens to "impair bank profitability forever"?

    http://ftalphaville.ft.com/2012/07/04/1071311/the-negative-carry-universe/

    I won't try to summarize it, because I don't fully understand it, but it looks like a version of the low interest rates are bad argument.

    Finally, you mention the idea that low rates deprive owners of financial assets (the rich ) of their accustomed returns. But one also often sees the argument that accommodative monetary policy drives up asset prices and hence benefits the rich. If anything, I'd say claims that QE etc. helps the rich are more common that claims low rates hurt the rich. I suppose both are true - it depends what kind of assets you own and how you get your income (capital gains, interest income etc.).

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  3. are some traders (and others characters) at banks paid not on the basis of the spread, but in some sense on the gross return they generate?

    I don't know -- the specifics of bank compensation aren't something I know much about. Altho I suppose if you can think of some kind of perverse incentive, there is probably bank paying people based on it.

    I suppose actors such as pension funds, hedge funds etc. are going to search for yield, as they always do. Is there anything more dangerous, w.r.t financial stability, about their behaviour when yields are low?

    Right, financial institutions always want the highest yielding assets, adjusted for risk. What's different about low rates? The argument here is that there is some floor on acceptable returns. If you fall below that you're screwed, regardless of how far below -- you can't be a little bit bankrupt if you're a firm, or a little bit fired if you're a trader. So when your expected return falls below the floor, you switch from being risk-averse to being risk-loving. This was definitely a real and important phenomenon in the S&L crisis (where people talked about thrifts "gambling for resurrection") but I don't think it's happening at banks now, for the reasons giving here -- it is not actually the case that bank returns are low.

    As I said to Max above, one could in principle make a stronger case for insurance and pension funds, whose liabilities are more or less fixed, but I don't think there's any reason to think this sort of thing is happening there either.

    Have you looked at this "negative carry" argument, put forward by FT Alphaville, that threatens to "impair bank profitability forever"? I won't try to summarize it, because I don't fully understand it

    I don't understand it either. I'm not saying there isn't anything there, but I'm not sure there is.

    Finally, you mention the idea that low rates deprive owners of financial assets (the rich ) of their accustomed returns. But one also often sees the argument that accommodative monetary policy drives up asset prices and hence benefits the rich. If anything, I'd say claims that QE etc. helps the rich are more common that claims low rates hurt the rich. I suppose both are true - it depends what kind of assets you own and how you get your income (capital gains, interest income etc.).

    Right! This is the really important part. Low rates, like inflation, are bad for rentiers -- for the rich whose claims on society take purely financial form. For "productive capitalists" -- the rich whose claims are tied up in specific enterprises -- low rates, like inflation can be good. But both groups of rich are threatened by sustained high levels of activity that drives up wages, and both *can* benefit from a depressed activity if it allows for a reduction in wages (including social wages). I think that is the real agenda behind a lot of this stuff, at least unconsciously.

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  4. thanks JW

    minor quibble - if I am a rentier and my claims on society consist of corporate stocks, then low rates have been good for me because they've driven up stock prices. Although I'd better sell up, cash in, and buy that Caribbean island I've been eyeing up, because higher stock prices mean a lower dividend yield and expected future capital gains, all else equal.

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  5. Well, I suppose this is part of your Ph.D....

    There is a chance that 1 and 2 might be of some help.

    (1) About the increasing spread post 1980: seems to have been an international phenomenon (graph 3, difference between average mortgage rate, new business and government bond rate):http://rwer.wordpress.com/2013/04/27/interest-rates-the-long-run-netherlands-1590-2012-3-graphs/

    (2) For the Netherlands, the Centraal Bureau voor de Statistiek calculated (basis: national accounts)that low funding costs implied a whopping 1% a year of GDP transfer to the banks, in 2009. Must have been about the same in 2010-2012. http://www.cbs.nl/nl-NL/menu/themas/financiele-zakelijke-diensten/publicaties/artikelen/archief/2011/2010-08-16-twbankwezen-tk12.htm Don't be sorry for the banks.

    (3)The whole idea behind low rates is of course the rape and plunder of the rentier with the intention to force him or her to start to make real investments (or to consume)instead of making financial investments. When people are clamouring about this it only shows that low rates are finally doing their job.

    Merijn Knibbe

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  6. Josh, I'm not finding that interest data at the link given. Did you compile it from the data there?

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    1. Yes, I calculated it from the numbers reported there. Nothing complicated, but not worth going through in this comment box. Email me if you want to discuss -- jwmasonnyc@gmail.com.

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  7. Hi Merijn!

    Thanks for the comment. You're always a reassurance to me that I'm not crazy.

    About the increasing spread post 1980: seems to have been an international phenomenon (graph 3, difference between average mortgage rate, new business and government bond rate):http://rwer.wordpress.com/2013/04/27/interest-rates-the-long-run-netherlands-1590-2012-3-graphs/

    Yes, that's a great post, I'd meant to comment on it. The long run stability of nominal interest rates is really an important fact.

    The whole idea behind low rates is of course the rape and plunder of the rentier with the intention to force him or her to start to make real investments (or to consume)instead of making financial investments. When people are clamouring about this it only shows that low rates are finally doing their job.

    Exactly! An interesting fact along these lines, which I've never seen properly discussed, is that the biggest investment boom in postwar US history came in 1977-1981, when capitalists were supposedly doing terrible. And they were doing terrible: but holding real assets was less bad than holding money. I think there's an important lesson here.

    Well, I suppose this is part of your Ph.D....

    Sort of. But the real story is that I wrote this three weeks ago, right after the linked DeLong post, and just for some reason didn't put it up. And then a couple days ago, Mike Konczal asked me, "Hey, what happened to that thing you were writing about Jeffrey Stein and reaching for yield?" And I was like, oh, right, that.

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  8. The thing I find unsatisfactory about the reaching for yield story is that it is a story of banks choosing high risk loans over low risk loans. But I've heard very little about the second half of the story -- tell me about all those who should be in more debt, want to be in more debt, but couldn't go into debt because, though they are low risk, banks were passing them over for higher risk debtors that promised potentially higher rewards. Is that really the situation we were or are in?

    My impression is more that banks were taking on higher risk loans because they were having no trouble filling the low risk loans, and were able to lend more on top of that. And what happens when banks would like to be lending more but the most promising debtors have been given loans already? Rates drop. The fact that rates could be this low without causing inflation is a sure sign that we have lots of saving available to be lent that we just can't discourage and are having difficulty finding the right people to lend it to to create demand. So I think low rates are related to the problem, but they are a symptom of the problem not the cause.

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  9. On this topic today at Vox

    http://www.voxeu.org/article/measuring-reach-yield

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