From Capital & Conflict (Great Britain) –
First, a correction from last week on the total per capita cost of Brexit, according to Bloomberg economist Tyler Cowen. You’ll recall that Cowen said you could expect a 10% decline in British exports because of a weaker (long-term) pound on Brexit. Because exports are 30% of British GDP, he calculated that the cost of Brexit was £5,365 per Briton.
Several readers noted that UK GDP is not £12 trillion, and therefore imports are not £3.6 trillion, and therefore a 10% decline from that figure cannot be £360 billion. And therefore the £5,365 per capita “cost” figure is rubbish. QED.
All too true. The confusion is that Cowen’s £12 trillion figure comes from his calculation of “net British assets and wealth” not UK GDP. He adds up net household wealth (around £9 trillion) and estimates that the UK government’s land holdings and “other assets” add up to another £3 trillion. Presto! You have £12 trillion in “national wealth”.
UK GDP, of course, is not £12 trillion. According to the Office for National Statistics, it’s about £1.8 trillion. Cowen equated imports as a percentage of GDP (and the decline he expects due to a lower pound) with imports as percentage of national wealth. That’s why the £360 billion is so high, being 30% of £12 trillion.
Or perhaps the whole exercise was rubbish. I’m not a professional statistician, but the methodology does seem pretty dubious. And in any event, the weaker pound (so far) has boosted the share prices of FTSE 100 listed multinational companies (so far). Whether that continues depends on the shape of the UK’s trade relationship with the European Union and the rest of the world post-Brexit.
But that’s probably the main point that we should all keep in mind. Whatever Brexit means, it hasn’t happened yet. You’ve had a declaration of intentions by the British people. But in practical terms – other than the UK not being present at the weekend EU summit in Brat islava (the first time in 43 years the UK hasn’t been represented at an EU meeting) – nothing really has changed. Especially anyone’s mind.
Sibling rivalry at the BoE
Now back to markets. They’re quiet today. Tomorrow’s the “big one”. The Fed meeting and decision everyone’s waited for. And then what will the mercurial Bank of Japan do? Will it find a way to extend the horizon of quantitative easing as we know it? Or will it finally publically admit that QE has been a failure and that even in terms of boosting financial asset prices, the returns are diminishing and marginal?
Before we hear from those two venerable mouthpieces of financial authoritarianism, we’ll hear from the unassuming Financial Policy Committee (FPC) of the Bank of England. The FPC is the lesser-known little brother of the interest rate setting Monetary Policy Committee (MPC). But maybe it’s finding its voice.
In early August, the FPC released the minutes of the meeting it held in late July. You could almost hear the tentative note of caution in the discussion. Maybe, just maybe, there are people at the bank who realise you can have too much of a good thing. That interest rates can only go so low for so long before they start causing more harm than good. Here’s an excerpt from the notes (emphasis added is mine):
Stimulative monetary policy should support financial stability through an improvement in the outlook for economic activity and employment. There could be circumstances in which implications occur for financial stability, including where benchmark interest rates are very low or negative. For banks, such implications include the impact of low benchmark rates on banks’ net interest margins…Downside risks to insurance companies and pension funds from falls in the yield curve arose from the impact on valuation of their liabilities – and from the potential for this to affect their investment behaviour, and, therefore, market functioning.
Ah yes. The double-barrelled risk of low rates for pension funds and banks. The crunch in net interest margins makes banking an even tougher business than it already is. Low yields on government bonds make it hard for insurance companies and pension funds to generate sufficient returns on their assets to match their liabilities.
But it’s the last risk that’s scarier for investors. If you’re a pension fund or insurance company and low interest rates make it harder for you to meet your long-term liabilities, you either have to reduce those liabilities or increase the risk you take in markets to generate a bigger return. Your “investment behaviour” goes from prudent long-term planning to aggressive short-term speculating.
When you see this happen all across the economy – from banks and pensions funds to households and small businesses – then you start to see the real cost of a low and negative rate monetary policy. Central bankers send the signal that it’s okay to stack on debt. Worse than that, they effectively force more dangerous risk-taking by financial participants who have no real interest in taking risk.
It doesn’t have to end in tears. But it does generally lead to more volatility, bigger daily swings in stock and bond prices, and, eventually, bigger losses. That’s why I’m with Tim Price on the issue. QE can’t end soon enough. Sign Tim’s petition to end QE here.
DB’s $75 trillion derivative problem
Once Britain moved out of the house, things began to get testy in the European Union. Italy’s prime minister Matteo Renzi took a shot across the bow of German central banker Jens Weidmann yesterday. He alluded to problems within the German banking sector and “the hundreds and hundreds and hundreds of billions of euros of derivatives,” according to Reuters.
Ouch. He was, of course, referring to the notional derivatives exposure of Deutsche Bank (DB). That exposure is around $75 trillion, which is a big number. It’s 20 times German GDP, slightly more than GDP for the entire world, and greater than the total market value of all the listed stocks in the world (according to World Bank data).
Hence the question: would the fall of Deutsche Bank take the rest of the world with it?
Before you begin packing your bug-out bag to head for the hills, please note that the notional amount of derivatives exposure may not be what you think it is. A full discussion of derivatives is beyond the scope of today’s letter. But you can’t just drop a figure like $75 trillion into polite conversation and leave it there. So let me (briefly) explain.
The $75 trillion figure is further proof of what I showed you yesterday. DB is a “globally systemic important bank” because it’s so interconnected with the rest of the world’s financial system. That interconnection comes, partly, in the form of derivatives. But what does that mean?
To grossly simplify, derivatives are for hedging risk. Banks buy them. Banks sell them. It’s a massive market. But does the $75 trillion value of DB’s derivatives exposure mean it could quickly lose $75 trillion and destroy the world’s financial system? Probably not.
I say “probably” because the “notional” value is not the same as “net exposure”. Most hedges, like options, expire worthless. The things they are designed to hedge against never happen. The “net exposure” is supposed to more accurately reflect how much money a bank could lose if something bad happened in the market and it lost money on its hedges.
Of course, the purpose of hedging is to avoid losses and insure yourself against unexpected risk. That’s why the “net exposure” figure is always lower than the notional figure. Assuming the bank’s risk management is properly designed, the hedges roughly cancel each other out and the amount of value actually at risk is quite low.
That’s the theory. The trouble with any theory is the model you’ve based it on. If your model doesn’t include the possibility of something really bad happening – like a sovereign bond default for example – then your actual value at risk may be much higher than you think. Your hedges won’t cancel each other out. And then your losses, via your interconnections in the financial system, might be transmitted to other firms.
That’s what keeps everyone up at night with DB. It’s connected to everyone in Europe. If it has a problem, and the problem gets bad, it’s everyone’s problem. $75 trillion in gross notional exposure looks like a virus in search of a victim. Let’s hope it’s not.
Also, Tim Price has been working on the theory that the EU’s next banking crisis may start in Italy. There the problem is bad and non-performing loans left rotting on the balance sheets of banks that can’t or won’t reform. Part of the problem is that ordinary savers are large creditors to Italian banks. A loss to creditors is a hammer blow to savers, which politicians want to avoid.
The German banking problem – at least with respect to Deutsche Bank – is really a much larger version of the problem you saw with Long-Term Capital Management (LTCM) in 1998 and then with Lehman Brothers in 2008. And what was that problem?
Models on which hundreds of billions of dollars and pounds are risked are based on the work of mathematicians and academics. Those models have consistently under estimated the probability and the magnitude of really bad things happening in the real world (the US housing bust). The model makers find out the hard way that the risk was always greater and the losses always bigger than they ever imagined possible.
Is it a failure of imagination? Or is it just too much belief that human beings behave in a rational way? It’s probably a bit of both. And also hubris. The investment industry has been invaded by Ph. Ds and theorists. They believe they’re able to model human behaviour and risk better than ever before in history. When they’re wrong – and at some point they’re almost always wrong – things fall apart.