David and Goliath

by
Frances Coppola
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The "unknown person with few followers" was my protagonist. And the blue tick "classical expert" was me. I am Goliath. 

But ten years ago, I was David. Armed only with Blogger and Twitter, and my knowledge of banking and finance, I set out to slay the financial Philistines that rampaged across the internet in the aftermath of the 2008 financial crisis. I published my first Coppola Comment post on 20th February, 2011. It throws slingshots at a media pundit who had written an article about short selling, on which he was far from expert. You can still read it, if you like. 

My early posts were rough and ready, and my terminology is at times excruciatingly loose, but I was sure of my subject. I understood British banking and financial markets well, though I had left RBS nearly ten years before. It was evident to me that the 2008 financial crisis in the UK was one of retail banking, not investment banking. The banks that failed, with one notable exception, were retail banks that had over-extended themselves in property and commercial lending, and in some cases had also invested in toxic securities as part of their treasury function. The European banks that failed in the crisis were similarly over-leveraged and riddled with non-performing loans and toxic securities. I was critical of regulators, central banks, the banks themselves, and above all the self-appointed pundits promoting bank breakups and ring-fencing, neither of which I considered an appropriate response to the crisis. 

Now, re-reading what I said ten years ago, I wince at my writing style but nod my head at the message. Banks did have insufficient capital and inadequate liquidity, central banks were too slow and too limited in their response to the crisis, and regulators were asleep at the wheel. Now that banks have better capital and more liquidity, regulators have tighter control of their activities (perhaps even too tight), and central banks are more active in markets, ring-fencing has turned out to be pointless. Banks pretty much broke themselves up to meet tougher capital requirements. There's not much left of British and European investment banking now.  

But the financial crisis originated in the American mortgage market. The Philistines talked as if all mortgage markets were the same, but in fact the American market is unique in the world. And it is the unique structure of this market that enabled an American crisis to propagate itself across the world. 

I knew what adjustable-rate mortgages were - after all, the entire UK mortgage market consists of adjustable-rate mortgages - and I knew what a subprime mortgage was like, having had one myself (my first mortgage was 100% LTV). But I was amazed to discover that most American mortgages are fixed-rate for 25 or 30 years. Adjustable-rate mortgages were inevitably subprime, because people took out adjustable-rate mortgages if they weren't creditworthy enough to qualify for prime fixed-rate mortgages. These people were generally on lower incomes and therefore more sensitive to interest rate rises than the average borrower, and yet the average borrower was protected from interest rate rises while they were fully exposed to them. It was a mind-blowingly stupid market structure. 

Furthermore, the US was exporting its mortgage interest rate risk. Whereas in Britain and Europe mortgage lenders generally keep mortgages on their books, American mortgage lenders (known as "originators") sold on the loans: prime mortgages (and in the mid-2000s some subprime too) went to the Government-Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac, while adjustable-rate subprime mortgages went to investment banks. GSEs and investment banks alike issued securities backed by these mortgages and sold them to international investors. "Tranching" and the use of structured instruments such as collateralized debt obligations (CDOs) made it possible for many securities to be sold as safe assets even if they were backed by subprime mortgages. And derivatives such as credit default swaps helped to distribute US mortgage default risk out to the far reaches of the capital markets universe. 

I understood securitisation and derivatives. My MBA dissertation is about derivatives, and I spent quite a bit of my banking career devising systems for managing derivative exposures and structured products. I didn't know the Gaussian copula equation used to price CDOs, but I was familiar with the related Black-Scholes equation for derivatives pricing. But I had never seen systematic securitisation before, and I didn't know how tranching worked, though I understood capital structures. So I had a steep learning curve in those early months. But I did the research, and I found out how it worked. And then I wrote about it. You can still read my "sausage factories" explanation of how securitisation and tranching spread an American subprime mortgage crisis to the whole world. 

I was not the only David taking aim at the Goliaths of conventional finance and economics at that time. Writers such as Cullen Roche and Edward Harrison, and heterodox economists such as Steve Keen and Ann Pettifor, were as determined as I was to correct the widespread misunderstanding of so-called "fractional reserve" banking that had resulted in central bankers failing to understand the risks posed by rising leverage in the banking system. 

It quickly became apparent that central bankers and economists not only didn't understand how banks could crash the world, they didn't understand their own tools either. They simply did not know how money is created in a modern economy. They thought quantitative easing (QE) must be used sparingly to avoid triggering runaway inflation, because banks would lend out all those new reserves at 10 times leverage, wouldn't they? 

But banks don't lend out reserves. And they don't "lend out 90% of deposits keeping 10% in reserve", either. They lend, creating new deposits in the process, then borrow reserves if they need them to settle the drawdown of those deposits. The new deposits add to the total amount of money in circulation - to be clear, because of the way we measure money, they do so before they are drawn, not as a result of being drawn. So bank lending creates new money. 

When bank lending is out of control, so too is money creation. And when there is a liquid interbank market, reserve availability does not constrain lending, because banks can always borrow what they need: central banks that are using the interbank lending rate as their principal inflation control tool will always ensure there are sufficient reserves for banks to borrow, since if they do not, they will lose control of inflation. 

Furthermore, when lending is mainly against property, it does not raise consumer price inflation: people are borrowing to buy property, not to spend on consumer goods. So while banks were lending more and more, driving up property prices to the skies, central banks that were only watching the consumer price index were unconcerned. 

Thus, prior to the crisis, bank lending was unconstrained by reserves or regulation. And although their loans were undercollateralized, their borrowers skint and their capital paper-thin, they thoujght they were safe, because the value of the collateral against which they were lending was constantly rising. Central bankers also thought they were safe, because inflation was low and stable. And governments thought they were safe, because the economy was growing strongly and tax receipts were rising. When the whole house of cards collapsed, everyone scratched their heads and muttered, "how did that happen?" 

After the crisis, banks didn't want to lend, to each other or anyone else. Their balance sheets were overleveraged and stuffed with non-performing loans. They were under pressure from regulators to reduce their risks and clean up their underwriting standards. So, far from banks increasing lending in response to QE, they actually reduced lending despite QE. The "second bailout for banks" headline that is famously etched on Bitcoin's genesis block is a reference to the desperate measures considered by the UK's then Chancellor of the Exchequer, Alistair Darling, to try to get damaged banks to start lending again. 

So when central banks provided banks with copious quantities of new reserves in the expectation that they would lend them out, banks simply ended up with far more reserves than they knew what to do with. They gratefully parked their excess reserves at central banks for a few basis points in interest, thus ensuring that the few banks that did need to borrow reserves had to do so at a positive interest rate. "Banks are being paid not to lend," muttered mainstream economists. But as many of us pointed out, had central banks not paid interest on excess reserves, the main policy rate would have fallen below zero. At that time, no-one wanted to experiment with negative rates. So it's not so much that banks were being paid not to lend, it's more that they were being paid to lend to each other to prevent the main policy rate from turning negative. 

The terrm "fractional reserve lending" is thus extremely misleading. Banks lend, creating money in the process: as a consequence of the lending and drawdown process, banks end up with fewer reserves than they have deposits. In this era of excess reserves and Basel liquidity regulations. reserve requirements intended to ensure that banks always have sufficient reserves to meet normal daily deposit withdrawal requests are redundant: in March 2020, the Fed abolished its iconic10% reserve requirement, the source of the "10% reserve" of the money multiplier model. 

It is capital, not reserves, that constrain lending. Reinforcing this message, and explaining how bank lending really works, has formed a large part of my writing over the last decade. 

But even now, the same old nonsense about fractional reserve banking and money multipliers is still circulating. Ordinary people repeat it to me because they've seen it on Facebook. Teenagers too young too remember the financial crisis pontificate about it with extraordinary assurance because they remember it from their high school economics classes or because some crypto bro on twitter told them about it. People tweet blogposts they've written using the failed money multiplier model to explain how banks work. Old economic models never die, they just hide in the dark corners of the internet and in economics textbooks.   

And it's not just nonsense about banks that is still being spread. Nonsense about money is, more widely. QE is still being called "money printing", including by mainstream media journalists and pundits who should know better. People are alleging that central banks are directly financing government deficits, even though this is illegal in most Western countries. And the goldbugs I spent so much of my time arguing with all those years ago are back in force, promoting their deflationary hard-money regimes and descriibing the fiat money creation that is currently keeping people alive as "immoral". To me, failing to give people the money they need to keep them alive is immoral. Better some inflation than poverty and starvation. 

Anyway, I've heard all this inflation scaremongering before. It was wrong ten years ago and it is equally wrong now. QE does not cause inflation, and nor do government deficits when the economy is in a slump. We are living through an era of "QE for the People" right now, and there is no significant inflation. There will probably be a short burst of inflation as the economy reopens, because the damaged supply side will take a while to catch up with resurgent demand, but neither the exceptional government spending during this time nor the monetary policy that supported it will cause runaway inflation. 

We are doing now what we should have done after the financial crisis. It is vital that the inflation hawks, bond vigilantes and goldbugs aren't allowed to derail this train as they did the last one. The consequences if they do are too ghastly to contemplate.

And so I find myself, once again, fighting against the spread of nonsense about banking and finance on the internet. But to the new kids on the block, I am part of the establishment that they blame for their troubles. They insist that central banks will cause inflation with all this "money printing", and when I say "it doesn't work like that", they tell me I don't understand how money works. They have never read my work, and they don't want to: they only know that I am a blue tick and a "classical expert". To them, I am a dinosaur, and when the cryptocurrency asteroid strikes, I will die. I have become Goliath, to be slain, not listened to. 

The price David paid for slaying Goliath is that he became the new Goliath. Did King David ever long to be back on that hillside tending his sheep? These days, I would rather be in the garden tending my plants than wielding a slingshot against a new tide of internet Philistines. 

Someone even suggested yesterday that if I wanted to talk sensibly about money I should write a blog. I laughed hollowly and pointed them to this blog. But there are a lot of posts on this site, and it's not very well organised. Blogposts, like Twitter, are ephemeral: once the occasion has passed, it can be hard to find them again. So maybe I need to organise my old posts into an indexed archive. Or maybe I should turn them into a few e-books. What do you think?

More importantly, Blogger is an old and tired platform, It's increasingly unpleasant to use: I have to manipulate the HTML to make the posts look half decent. I had to add code to comply with GDPR, but as a result my own domain, coppolacomment.com, can't be found on search engines now, though individual blogposts can. And Blogger is withdrawing the subscribe by email facility in July 2021. It's almost as if Google doesn't want to maintain a CMS for casual bloggers any more. So I am thinking of shutting down this site. Not to throw away what I have done in the last decade, but to draw a line under it and move on, at least to a better platform. 

The last ten years have been a blast. I have learned an immense amount, and achieved more than I ever imagined possible. I am no longer the singing teacher from Kent who knew a bit about banking and was surprised to find she could write. I'm a professional writer, a published author and an acknowledged expert on banking, finance and monetary economics. In a way, I really have become Goliath. I am proud of that, and immensely grateful to all the people who have helped me along the way. 

But I am also still David. I still scrape a living from freelance writing, singing and teaching: senior jobs in central banking, thinktanks and financial publications have entirely passed me by. And I still want to slay the resurgent Goliaths. Indeed, I'm currently writing a book called "The Absolute Essentials of Banking", because even now, more than a decade after the financial crisis, people still don't understand how banks work. And I continue to wield my slingshot on the internet, even though I really prefer being in the garden. Some things are too important to give up. 

Related reading:

David and Goliath, 1 Samuel 17 - Bible Gateway