Author Archives: Stubborn Mule

Cypriot sovereignty surrendered

Here is a rant about events in Cyprus. Normal dispassionate service will resume here at the Mule in the next post.

Over the weekend, the European crisis took a sickening new twist in Cyprus. The government of Cyprus announced a “levy” on Cypriot depositors as part of a deal to secure a bailout of its ailing banks by international lenders. In doing so, it has dramatically demonstrated how completely Cyprus and other eurozone nations have surrendered their sovereignty to the technocrats of the European Commission, the European Central Bank (ECB) and the IMF.

The president of Cyprus Nicos Anastasiades has told his citizens, subject to getting the numbers in parliament, his government is about renege on past promises and appropriate the savings of pensioners to make good the failings of others. This is not the first time that the global financial crisis has claimed innocent victims, but it is perhaps the most striking example of this phenomenon.

Cyprus’s financial woes stem from the fact that their banks had significant investments in Greek government bonds. Back in March 2012, as part of the bailout of Greece, investors in these bonds suffered a “haircut” of 53.5%. Somewhat less euphemistically, holders of these bonds lost more than half of their investment. This left Cyprus’s banks in deep trouble and, while negotiations with Europe for a bailout continued, the ECB kept them afloat with emergency funding. The threat of suspending that ECB support was the gun to Anastasiades’s head that led him to agree to the disgraceful bailout scheme.

As the European crisis has rolled on, the European technocrats have become increasingly committed to “private sector involvement” (PSI). At face value, the principle is sound. The use of public money to rescue private sector banks leads to moral hazard. If lenders to banks expect to be bailed out, they may be tempted to allow banks to be ever more reckless in their risk-taking.

When a bank suffers losses, there is a hierarchy that determines who will suffer losses. The hierarchy typically works like this: investors in the bank’s shares are the first lose their investment; next to lose are investors in so-called “hybrid debt” (not quite lending, not quite equity, this includes things like preference shares); if the bank has issued “subordinated debt”, investors in these securities come next, followed by “senior debt” providers (typically in the form of bank-issued bonds). Depositors are the last to lose money and retail depositors with small balances typically have additional protection in the form of deposit protection provided by the government or a government agency*.

Depositor protection is extremely important. Despite being private companies, banks provide a critical role for the smooth running of an economy and so cannot be left at the mercy of the “creative destruction” of capitalism. In today’s society it is not really possible to opt out of the banking system and simply being paid a wage requires a bank account. It would be impractical, inefficient and unreasonable to expect every retail depositor to analyse the financial health of their bank before choosing where to deposit their money. When a bank collapses, shareholders should lose money. Wholesale investors should lose money. Retail depositors should be protected.

This reality is not lost on the lawmakers of Cyprus and for over 10 years, Cyprus depositors have supposedly been provided with deposit protection on balances under €100,000. The details of the levy have not yet been finalised, but the initial proposal involves a levy of 9.9% on all deposit balances over €100,000 and 6.5% on all deposits below €100,000. Anastasiades has effectively said, Oh, that deposit protection scheme? Well we had our fingers crossed when we made that promise. That explains the weasel word “levy” or “tax”. Of course your deposits are still protected against losses. You will not suffer a loss, it’s just that there’s a new tax we’re bringing in…

As if this dramatic breach of faith was not enough, there is no moral justice here either. Like Ireland before it (and indeed Australia), Cyprus did see rapid growth of private sector debt in the lead up to the crisis. So why not levy the tax on reckless borrowers not prudent savers?

Cyprus should rue the day that it surrendered its sovereignty by joining the euro zone in 2008. Cyprus would still be facing economic challenges today, but it would be free to determine its own fiscal policy, stimulate the economy (if it managed to keep politically-motivated deficit hawks at bay) and, of course, it would be able to honour its promise to protect retail depositors.

* Before the financial crisis, Australian depositors had no deposit protection. The assumption was that prudential oversight of banks provided sufficient protection for depositors. That changed after the crisis and now deposits below $250,000 are protected.

Account Keeping

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I have been digging through some family archives and came across an old bank passbook belonging to my great grandfather, William Booth. He lived in Perthville in the central west of NSW. His account was with the Bank of New South Wales, Bathurst branch.

Pasted inside the front cover is a statement of the account keeping fees. I was born after decimalisation, so 5/- was not immediately meaningful to me. It turns out that the semi-annual fee is five shillings. To complicate matters further, the first transaction in the passbook is dated 1903, so these are British shillings. Australia did not introduce its own currency until 1910.

Having worked out that much, I was interested to compare 1903 account keeping fees to account keeping fees today. So, the next step was to convert five 1903 British shillings into present day Australian dollars. The website Measuring Worth comes in handy for this purpose. The site’s banner features the following quote from Adam Smith’s The Wealth of Nations (1776).

The real price of every thing, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it… But though labour be the real measure of the exchangeable value of all commodities, it is not that by which their value is commonly estimated… Every commodity, besides, is more frequently exchanged for, and thereby compared with, other commodities than with labour.

With that in mind, it provides a range of present day values for five 1903 shillings. Well, almost present day: their data series extend to 2011, so in 2011 terms five shillings is worth any one of the following

£22.00	using the retail price index
£26.00	using the GDP deflator
£86.80	using the average earnings
£134.00	using the per capita GDP
£200.00	using the share of GDP

Back in the day of William Booth, account keeping involved someone manually reconciling three columns of pounds, shillings and pence. These days the process is computer-assisted, so a retail price adjustment may be more appropriate than average earnings or any of the other measures.With UK inflation running at 2.6% over 2012, I can tweak £22.00 to £22.57. Using the current exchange rate, that amounts to A$33.33. Strictly speaking, even though Australia used British pounds in 1903, I should use an Australian retail index, but as Measuring Worth only has US, UK, Japanese and Chinese conversions at the moment, I will stick with the British approach.

So, Mr Booth was paying just over $5 per month in service fees for his banking. The Bank of New South Wales has since become Westpac. According to the Westpac website, the monthly service fee for the “Westpac Choice” transaction account is $5. Fees at other banks would be very similar. So, perhaps surprisingly, account keeping fees seem to have changed very little over the last 110 years!

Given the level of automation in banking today, it would be reasonable to expect that fees would be lower than they are today. Certainly if the five shillings were adjusted based on average wages, the cost of Mr Booth’s account keeping would be more like $20 per month. Not only that, like every other bank, Westpac also offers a basic account option with zero account keeping fees. I am sure that would not have been an option in 1903.

Prisoner of Speed

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A favourite podcast of mine is known in our household as “Danny’s podcast” in honour of the friend who first put me on to it. The podcast is better known as Radiolab and last week’s episode turned on the theme of Speed. After answering the question, what is the fastest sense, attention turned to high-frequency trading. As the Radiolab hosts are more comfortable with science than finance, they turned for assistance to David Kestenbaum from the Planet Money podcast.

In a past Mule post, I expressed reservations about the merits of high-frequency trading. Just last year, there was talk in the European parliament of enforcing a delay on electronic trading. Some critics argue that high-frequency trading creates instability in financial markets and may have been to blame for the “flash crash” of 2010.

One of the more intriguing aspects of high-frequency trading was brought out in the podcast during an interview with a technologist from the US trading firm Tradeworx. Bemoaning the cost of constantly competing to allow faster and faster trading (millions of dollars are being thrown at shaving milliseconds from the time to send trades to an exchange), he said that high-frequency traders were caught in a prisoner’s dilemma.

The prisoner’s dilemma is a staple of the study of the branch of mathematics known as “game theory“, which seeks to analyse strategic decision-making. Here is a quick overview for anyone unfamiliar with it.

Two criminals are arrested and taken to separate cells to ensure they cannot communicate with one another. The police have enough evidence to send each man to jail for one year. With a confession the police could get a conviction on a more serious charge. So, the police point out to each prisoner that cooperation will help reduce their sentence. If neither prisoner confesses, both will face one year in prison. If one testifies against his partner in crime, he will go free while the partner will get three years in prison on the main charge. But, if they both confess, that cooperation is not worth as much and both will be sentenced to two years in jail.

So, what should each prisoner do? No matter what the other prisoner does, confessing will improve their outcome, either from one year to none if the other does not confess, or from three years to two if the other does confess. So, the only rational thing to do is to confess. If both prisoners follow this logic, they will both get two years. And yet, if they had both kept quiet, it would have only been one year each, which would be better for both of them. The problem is that the “global optimum” is hard to obtain because there is too much of a risk for each prisoner that the other will defect.

The same is true for the high-frequency traders. While it might be cheaper for all of them to call a truce and freeze their technology at its current state, there would always be the risk that one firm breaks the truce and gains an edge. So, they all continue to compete in the speed race.

But the prisoner’s dilemma applies to more players than just the trading firms themselves.

If one of the major exchanges, such as the NASDAQ tried to stop the speed race, then it may well find itself losing business to any other exchange which continued to facilitate faster trading. An exchange without trading does not last long.

Governments too face the dilemma. There is already intense competition between exchanges operating in different countries and no government would want to lose the kudos and, more importantly, revenue that comes with playing host to a major financial centre. Would the UK government, for example, want to put London at a disadvantage to Europe or the US? Unlikely.

The German government is now delaying plans to curb high-frequency trading, in order to “clarify technical details”. I suspect that this will turn out to be a rather long delay.

Where is the money coming from?

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It has been quite some time since I wrote about the mechanics of money, but today I am at it again. The catalyst is not, as some might expect, the recent discussions about the possibility of the US Treasury minting a trillion dollar coin, but rather a recent discussion I had with a banker about deposits on a small tropical island.

While deposit levels at banks in Australia are below upcoming regulatory minimums, leading to intense competition in the pricing of term deposits, the banker I spoke to was facing the opposite problem in the small nation of Paradise Island (not its real name).

As he told the story, despite offering rather unattractive interest rates on deposits, deposit balances had continued to grow. Worse, demand for loans was weak and so the bank was forced to keep growing balances on deposit with the island nation’s central bank. Since banks like to diversify their investments, this situation was not ideal. Ordinarily, he said, deposits would build up as exporters took in payments for their goods, but periodically these balances would be swept out again as they remitted their profits to offshore parent companies. This did not seem to be happening any more. Exactly why these deposits were growing was a mystery and, short of closing the doors of all their branches, he did not really know how to stop these balances from growing.

With years of reading Bill Mitchell under my belt, I knew that the way to think about this question was to take a macro perspective rather than thinking from the perspective of one bank.

The first thing I focused on was the balances with the central bank. A popular misconception is that banks can choose between holding deposits with the central bank or lending the money to their customers. In fact they cannot. The central bank itself only has two types of “customer”: banks and the government. You and I cannot walk into the central bank and open up an account. This means that the only thing that can happen with central bank balances is that they move around from one bank to another or to and fro between the government and banks.

Imagine for a moment that the bank arranges a $100,000 loan for me to buy a nice little shack on one of Paradise Island’s beaches. If the shack vendor banks with my bank, then our bank will see both its loans and its deposits increase by $100,000. On the other hand, if the vendor banks elsewhere, my bank will have to transfer $100,000 to the vendor’s bank. This is done by moving money between the banks’ respective accounts with the central bank. So, in this case, my bank has an increase in its loans of $100,000 and a decrease of $100,000 in its deposits with the central bank. But that central bank deposit has not left the system (and it has not gone to me). Rather, it has moved from one bank to another.

While there will be movements in central bank balances in this fashion from one bank to another in the normal course of business transactions, balances will tend to average out to reflect each bank’s market share. So, my banker friend is unlikely to be alone in seeing deposits with the central bank growing. Indeed, looking at the aggregate bank balances with the Paradise Island central bank, it becomes evident that there is a systematic trend.

Aggregate Balances with the Central Bank

So how does this happen? The most likely explanation is that the balances are coming from the government. As the government spends money, behind the scenes there will be money moving from the government’s account at the central bank to the accounts of commercial banks. This can happen if the government is running a deficit, spending more money than it is receiving. But that is not the case here. In fact, Paradise Island has been running a surplus of late.

A bit more digging through the national accounts reveals the answer. Paradise Island receives aid from larger developed nations and the government has been spending most, but not all of this aid. The twist is that this aid has come in the form of foreign currency, which the government then deposits with the central bank in return for local currency balances which it is then able to spend. As a result, the central bank’s foreign asset balances have also been steadily growing. The similarity of these two charts is no coincidence: the two sides of a balance sheets must balance and the growth in the central bank’s assets directly mirrors the growth in their liabilities, in the form of commercial bank deposits. This is an example of what is known as “grossing up the balance sheet”.

Foreign Assets of the Central Bank

So the growth in bank deposit balances with the central bank has nothing to do with Paradise Islanders hoarding money or choosing not to remit their profits offshore. Instead it is the direct result of the government spending its aid money. If the local banks want to have less of their money tied up in deposits with the central bank, rather than pointlessly trying to incentivise their customers to borrow or place their deposits elsewhere, they should consider encouraging the central bank to sell some of their foreign assets, reversing the grossing up of the balance sheet.

For me the most interesting aspect of this discussion is the fact that even if you can see exactly what is going on inside your own institution, it can be difficult to understand the workings of the system as a whole.

Are you mad, sir?

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Even if you haven’t heard of Jon Ronson, you have probably heard of one of his books. He wrote The Men Who Stare At Goats, which has been made into a film starring George Clooney. I have just finished reading a more recent, if lesser known book by Ronson: The Psychopath Test. It is an intriguing, anecdotal exploration of the nature of madness, with a particular focus on psychopathy.

The book is loosely centred on the psychopath test of the title, better known as the Hare Psychopath Checklist in honor of its creator, Canadian psychologist Robert Hare or, more simply, PCL-R (“Psychopath Checklist – Revised”). On his journey towards a better understanding of anti-social madness, Ronson attended a training course in the use of the PCL-R led by Hare himself. Armed with this qualification, Ronson found his new ability to expertly identify psychopaths out in the wild gave him an exciting sense of power. It is a sense of power that readers such as myself can readily share: it wasn’t long before I was attempting to spot corporate psychopaths in the upper echelons of my own place of work.

Here is how the test works: through a more rigorous interview process than I have had the opportunity to perform, your potential psychopath is scored on a scale of 0 to 2 on each of the categories below.

Glibness/superficial charm
Grandiose sense of self-worth
Pathological lying
Cunning/manipulative
Lack of remorse or guilt
Shallow affect
Callousness, lack of empathy
Failure to accept responsibility for own actions
Need for stimulation/proneness to boredom
Parasitic lifestyle
Poor behavioural control
Lack of realistic long-term goals
Impulsivity
Irresponsibility
Juvenile delinquency
Early behaviour problems
Revocation of conditional release
Promiscuous sexual behaviour
Many short-term (marital) relationships
Criminal versatility

Roughly speaking, a score of 30 or more suggests you have a psychopath on your hands. Reading Ronson’s book, I got the impression that there are currently few treatment options for a psychopath and those that veer towards criminality rather than high-flying success in the corporate world tend to be locked up for a very long time.

Over a sherry at a recently opened Spanish bar in Sydney, with the help of a colleague, I attempted an analysis of the executive at my firm I considered to be the best prospect for a high score on the PCL-R. Sadly, we only managed to chalk up 20 points. Apparently not a psychopath after all and, while that score is still reasonably high, I have to further concede that there may have been some overly-enthusiastic interpretations of the checklist involved in the assessment.

My own attempt at psychopath diagnosis brought me to sympathise further with Ronson, who found that the thrill of power was, after a while, replaced by doubt. Perhaps things are actually a bit more complicated after all. Even an interview with Al Dunlap, initially a slam-dunk candidate for the label of corporate psychopath, particularly given his extensive collection of statues of animals of prey (psychopaths apparently tend to see the world in terms of predators and prey), left Ronson uncertain of the appropriateness of the label of madness.

The lesson then is that I should use my new-found knowledge of PCL-R with care. As should you. Even so, I will not delete the list from this post as a precaution. After all, you could easily find it on Wikipedia; such is the power and the peril of the internet.

Mixed prediction results: Cup 0, RBA 1

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With Green Moon winning the Melbourne Cup, Fiorente in second place and Jakkalberry in third, none of the Mule’s tips even rated a place. That leaves a tipping record of one for three, and I am sure it will only get worse if I keep up this “analysis” in years to come. Fortunately, many of my readers are kind enough only to remember my success in tipping Shocking back in 2009.

The Stubborn Mule RBA poll fared somewhat better. The poll results were close, with 55% expecting no change in the cash rate and 45% looking for a 0.25% cut. As it turned out, Reserve Bank kept rates on hold, preferring to wait to see the effect of their October cut:

Further effects of actions already taken to ease monetary policy can be expected over time. The Board will continue to monitor those effects, together with information about the various other factors affecting the outlook for growth and inflation. At today’s meeting, with prices data slightly higher than expected and recent information on the world economy slightly more positive, the Board judged that the stance of monetary policy was appropriate for the time being.

By my count, this makes four correct predictions of the RBA decision from the last four Stubborn Mule polls. The moral of the story: ignore anything you read here about horses, but there might be something useful to learn about interest rates.

Mule bites horse

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The Melbourne Cup is almost here again, which means that it is time for the Mule to perform some utterly bogus analysis with which to predict a winner. So here goes.

Once again, I will look to past winners as a guide. Picking on those characteristics readily available from a Google search, I have focused on handicap weight, sex and age. Starting with handicap weight, here is a chart of the distribution of weights broken down by decade.

In the early years, handicaps were typically much lower, but things have changed in recent years. On this basis, I will focus on handicap weights from 1980 onwards.

The peak of this distribution is around 54kg, so this is where I will focus my attention. There are four horses in the 2012 field which are to carry 54kg: Cavalryman, Mount Athos, Sanagas and Ethopia. To narrow this list, we turn to sex and age. The chart below suggests favouring a gelding between 4 and 6 years old or a horse (stallion) around 4 or 5 years old, perhaps even 6.

Cavalryman and Sanagas are both 7 year old stallions: too old, although Sanagas is trained by Bart Cummings who has 12 wins under his belt. Mount Athos is a 6 year old gelding, while Ethiopia is a 4 year old gelding, either side of the 5 year peak in the distribution. Since 6 year old geldings have a slight edge, my tips are as follows:

First Choice: Mount Athos

Second Choice: Ethiopia.

Honorable Mention: Sanagas

I should point out that, despite tipping Shocking in 2009, the Mule’s track record has been terrible. You have been warned!

UPDATE: it has been pointed out that Ethopia is in fact to carry 53.5kg not 54kg. While that may not seem much of a difference, there are another nine horses carrying that weight. While one school of thought would be to scratch Ethopia from the tip list, I would prefer to think that being the only one of the ten in that weight category to slip though, it must be lucky! On that highly scientific basis, Ethiopia stays.

Now Tuesday is not just about horses, there is also a Reserve Bank meeting. So, while contemplating a flutter based on spurious tips, you can also vote in a poll on whether there will be any change in the cash rate.

Once you have voted, you will be able to see the poll results.

What is Tony talking about?

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I first experimented with word clouds several years ago and used them to visualise the speeches of Kevin Rudd and Malcolm Turnbull. I have now learned from the Fell Stats blog (via R-Bloggers) that there is an R package for generating word clouds. The package makes use of tm, a text mining package for R, which I have been meaning to look into for some time. So, it seemed only appropriate to explore the speeches of Tony Abbott.

This word cloud shows the 150 most-used words in Tony’s speeches over the last 18 years. Perhaps disappointingly, since my efforts to strip punctuation also stripped apostrophes, “cant” actually only shows the frequency of the word “can’t”.

Pretty though the word cloud is, a little more can be gleaned from the word usage patterns through time. The correlation in recent years between “carbon” and “tax”, is clearly due to Abbott’s attacks on Labor’s imposition of a price on carbon. His stint as health minister is also evident. I did expect to see more of an impact from his “stop the boats” campaign (here the count for “boat” includes “boats”).

Abbott word count through time

Admittedly, there are no particularly deep insights here, but it was a fun way to learn about the tm and wordcloud packages.

UPDATE: In response to the comment from Dan, I have added a chart showing word frequency rather than count. This accounts for distortions arising from the larger number of Abbott speeches in recent years.

Abbott word frequency through time

For those who are interested, I have uploaded the (python) code for downloading the speeches and the (R) code for generating the charts to github.

Trust

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During the week I attended a farewell function for a retiring colleague. The turnout was impressive, a sign of deep respect earned over a career at the bank spanning more than forty years. In the speeches, a recurring theme was trust.

The primary business of a bank is lending money, which exposes the bank to credit risk, the risk that a borrower will be unable to repay the loan. On more than one occasion, our retiring colleague had turned down a loan based on prior bad experiences with the prospective borrower. Why would you lend money to someone who has lied in the past? Learning from past betrayals of trust proved time and again to be a wise risk management strategy.

In Trust: The Social Virtues and The Creation of Prosperity, Francis Fukuyama argues that trust has played a crucial role in the development of capitalism. While some point to the role of the rule of law for enforcing contracts in enabling business, Fukuyama emphasises that legal recourse only serves as a last resort. More important is the simple confidence of a handshake: the confidence that those you do business with will live up to their end of the bargain. Those societies which developed mechanisms for extending trust beyond small networks of families and friends were rewarded with greater economic success.

If trust is important for business, it is particularly so for banking. But, scanning the financial headlines over the last few months shows a banking system apparently intent on destroying society’s trust in banks and bankers.

Serious Fraud Office investigating the rigging of LIBOR rates

Barclays is just the first bank to be fined for allowing traders to manipulate the LIBOR interest rate benchmark. The scandal cost chief executive Bob Diamond his job and this story will be back in the headlines as the findings extend to other banks and civil cases unfold.

HSBC accused of providing a conduit for “drug kingpins and rogue nations”

Before a US Senate hearing, HSBC’s head of compliance faced charges that the bank had acted as knowing banker to Mexican drug cartels. He acknowledged that “there have been some significant areas of failure” and resigned his position there and then.

Standard Chartered alleged to have “schemed” with Iran to launder money

The BBC article in the link above is coy in its language. The New York Department of Financial Services is a little less so. Page 5 of their report quotes a Standard Chartered executive as saying, “You f—ing Americans. Who are you to tell us, the rest of the world, that we‟re not going to deal with Iranians?”

The front page of the Economist epitomises where this has led.

The worldwide reputation of bankers is at its lowest point, in my lifetime at least. The result will be new and more stringent regulation and more intrusive oversight of banks by regulators. This outcome will be well-deserved as banks have proved themselves unworthy of the trust of their communities. However, it is also likely to keep borrowing costs and transaction fees high as banks struggle to deliver shareholder returns while covering the costs of new regulatory requirements. So, it will not just be banks bearing the cost of their misdeeds.

Trust is hard to earn and, once lost, harder to recover. Every bank around the world should be thinking very hard right now about how to restore trust in banks.

Image searches

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This week’s edition of Media Watch, “Pixelating protects identity? Think again“, examines the threat image search engines pose to anonymity. Drop a disguised photo into Google images and the chances are you will find the original in the search results.

Intrigued, I thought I would try it out. The pixellated the photo of Tom Waits was my second test. The first image I found to try was a golden pyramid. (It is from a presentation I recently pulled together on cognitive dissonance, but that is unlikely to be a helpful explanation).

In this case the search results came close to being artistic: an impressive array of alternative golden pyramids.

I can see that Google images could be rather fun.