Moyse/Louisiana Bankers Association Chair of Banking at the Ourso School of Business, Louisiana State University; and Financial Industry Consultant at Empiris Economics, for his timely submission in regard to The Great Unwind Socratic dialogue. He writes:

Dear DK and Colleagues

Monetary policy effectiveness relies crucially on banks' willingness to lend, which all agree is now sorely lacking. The important consideration, however, is why? The fact of the matter is that, without adequately transparent financial measures investors and banks alike will not allocate funds to any borrower. With over fifteen times "off-balance sheet" exposures as "on-balance sheet" exposures in US and European commercial banks and the demonstrated possibility for those "off-balance sheet" items to unexpectedly come back "on-balance sheet" in times of distress, investors and banks are loathe to lend and will remain so until the absurdity of "off-" and "on-balance sheet" distinctions is put to rest.

The credit channel of monetary policy transmission consists of banks lending the proceeds from Open Market sales of Treasury debt to customers who use the funds to purchase goods and services, the sellers of which redeposit the proceeds in their own banks who relend the money again and again. Mathematically, the money multiplier itself consists of one divided by the reserve ratio that banks hold back to cover liquidity needs created by the deposits. Hence, if banks hold a ten percent reserve ratio, the money multiplier would be ten. In that event, if Open Market Operations inject USD 1 billion of Treasury debt purchases, the lending and relending of those funds through the banking system will result in USD 10 billion of new deposits and therefore economic activity.

The problem is that the reserve ratio consists of several distinct elements. First and foremost, there is the legal reserve ratio required of banks, which amounts to, on average, about ten percent. On top of that, however, is a level of discretionary reserves that banks desire. When times are good, the discretionary reserves are low: when times are bad, the discretionary reserves are high. Of course, as the discretionary excess reserve increases, Open Market Operations have less and less economic effect. In today's markets, therefore, banks desire high excess reserves to insulate their financial positions from continued economic shocks of the credit crisis and Fed Funds rate cuts have lost their effectiveness.

The problem is that policymakers have treated banks' behavior of holding increased excess reserves as somehow irrational instead of trying to better understand banks' motivations and disentangle the circumstances that have led to current desired levels of excess reserves. Policymakers, it seems, have resorted to Keynes's "animal spirits" explanation without pursuing first other rational explanations of banks' desire for reserves, and concomitant reluctance to lend.

One significant theme that runs through the credit crisis - though one that few want to talk about - is off-balance sheet financial arrangements. Before Basel I implementation in the US and Europe there was little in the way of off-balance sheet finance to speak of. But Basel I, implemented in recession at a time when raising additional capital - the numerator of the ratio - was hard, incentivised moving assets off-balance sheet to increase the ratio by reducing the denominator of the ratio in what we know to be a classic regulatory arbitrage. More importantly, it seems like regulators went along with the arrangements in order to bolster the apparent strength of US bank capital ratios and avoid what they felt at the time would be unnecessary regulatory enforcement that could potentially delay recovery from the 1991 recession.

Table 1: History of Commercial Bank Off-balance Sheet Exposures


In 1992, off-balance sheet items reported on Schedule M of commercial bank Reports of Condition and elsewhere (summarized in Table 1) and posted on the FDIC's web site amounted to some 2.9 times reported on-balance sheet items. By 2007, the multiple was 15.9 times. During the period 1992-2007, on-balance sheet assets grew by 200 percent, while off-balance sheet asset grew by a whopping 1,518%! Furthermore, the off-balance sheet numbers cited in the table do not include structured finance arrangements. Securitisations reported on Schedule S add about USD 2 trillion in 2007 and USD 1 trillion in 2004, but the data was not gathered in earlier years. SIVs, CDOs, CLOs, ARSs, CPDOs, etc are not reported to regulators and investors and therefore cannot be included in the comparison.

Policymakers, investors, and regulators have all learned recently that off-balance sheet isn't really off-balance sheet because it can come back on-balance sheet in times of financial distress, at which point the bank will have to raise capital to fund the exposure at current regulatory capital requirements. Such absurdity has investors and banks alike wondering the full extent of off-balance sheet arrangements and the probability that additional significant exposures can come back to banks in the near term, similar to movements associated with SIVs last summer, ARMs this spring, and now potentially RMBS in the Countrywide settlement. Even more important, however, is the fundamental fact that the sheer magnitude of off-balance sheet exposures precludes their being recognized at even de minimus capital requirements, especially in today's markets.

Hence, it is off-balance sheet shenanigans that maintain banks' and investors' reluctance to lend, but the widespread adoption of such arrangements in the years since Enron now makes it almost impossible for regulators and accountants to recognise the arrangements and appropriately capitalize commercial banks without tremendous economic disruption. Nonetheless, the longer we continue to deny the arrangements, resorting to "animal spirits" explanations of reduced confidence that continue to purportedly puzzle policymakers, the longer we perpetuate the downturn and threaten US and European financial markets preeminence as some of the most transparent and efficient in the world.

Best wishes


Joseph Mason

Prof Joseph Mason is the Moyse/Louisiana Bankers Association Chair of Banking at the Ourso School of Business, Louisiana State University, a Fellow at the Wharton School, Financial Industry Consultant at Empiris Economics, and a Visiting Scholar at the Federal Deposit Insurance Corporation. Professor Mason teaches in the areas of corporate finance, financial markets and institutions, and risk management and derivatives. Prior to joining Louisiana State University, he was an Associate Professor of Finance at Drexel University's LeBow College of Busin, a Financial Economist with the Office of the Comptroller of the Currency and Adjunct Assistant Professor of Finance at Georgetown University School of Business. His research spans the fields of corporate finance, financial intermediation, financial history, and monetary economics, focusing on issues related to both theory and public policy. He is the recipient of research grants or awards from the National Science Foundation, the Federal Reserve Bank of St Louis, Drexel University, and the University of Illinois. He serves or has served as advisor and consultant to many agencies and firms, including the Federal Deposit Insurance Corporation, the Federal Reserve Bank of Philadelphia, The Conference Board, the G-30, the World Bank Group, and numerous private firms. He is a member of the American Finance Association, the Financial Management Association, the Cliometrics Society, the Economic History Association, Beta Gamma Sigma, and Omicron Delta Epsilon.

Prof Mason has published academic articles in the American Economic Review; Journal of Business; Journal of Money, Credit, and Banking; Journal of Banking and Finance; Pacific-Basin Finance Journal; Journal of Financial Services Research; Research in Banking and Finance; and Explorations in Economic History, and book chapters in Resolution of Financial Distress (World Bank Group, Stijn Claessens, et al, eds); Privatization, Corporate Governance and Transition Economies in East Asia (NBER, Takatoshi Ito and Anne Krueger, eds); and Too-Big-To Fail: Policies and Practices in Government Bailouts (Greenwood Publishing, Benton E Gup ed). Prof Mason's current research projects include investigating the micro and macroeconomic effects of bankruptcy and liquidation procedures; the incidence and cost of systemic risk; and the management of idiosyncratic risks posed by new forms of bank lending, asset-backed securities, collateralised debt obligations (CDOs) and securitization. His work has been cited or published in the New York Times, Washington Times, the Economist, Wall Street Journal, Associated Press, Reuters, Bloomberg, KnightRidder Syndicate, MarketWatch-Dow Jones Newswire, MIST News, Financial Times, Barrons, Business Week, die Zeit, Investment Dealers Digest, American Banker, BNA's Banking News, Realty Times, Toronto Globe & Mail, the Philadelphia Business Review, and on CNBC, NBC Nightly News. He has made numerous live appearances on CNBC, Bloomberg Television, Comcast CN8 News, WBBM Radio Chicago, WHYY Public Radio Philadelphia, and WWDB Talk Radio Philadelphia.

[ENDS]

We are grateful to all sources for the information presented. We welcome your thoughts, observations and views. Thank you.

With love and warm wishes to you and family


DK with family

DK Matai

The Philanthropia, mi2g.net

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