Committing the NPRF

Should the NPRF be used for bank recapitalisation? 

I have always thought the fund a good idea.   It helped increase national saving by reducing measured budget surpluses.   (These surpluses would have been difficult to sustain politically.)  And I believed it would make pension benefits more secure in the face of a rising tax cost as the population ages.  Along with many others, I thought the fund only a good idea if investment decisions were not politicized.   That seems almost quaint. 

I now think it serves another purpose that I simply did not appreciate.   Others were more prescient.   It provides a valuable bulwark against the tail risk of a real “run-on-the-country” kind of crisis (that includes both bank and government debt).   The risk is nicely captured by Larry Summers in his 2000 Richard Ely lecture on international crises.   As he says, in this kind crisis the mode of investment analysis shifts from “economics to hydraulics.”  Fundamentals become irrelevant as everyone tries to get their money out before everybody else.  

The existence of a large and relatively liquid NPRF makes falling into such a bad equilibrium less likely.   I therefore think the Government should be slow to commit a large chunk of the fund to bank recapitalization.  My sense is that it would be better to borrow the funds, notwithstanding the recently increased spread.   Having a substantial liquid sum on the asset side of the government’s balance is valuable insurance in perilous times. 

Forget Bad Banks, Why Not New Banks?

I’ve written here before about my puzzlement over the widespread international enthusiasm for “bad bank” proposals and I haven’t changed my mind since.

A more attractive proposal, which is getting less attention, is the idea of establishing new banks.  It could be argued that this directly addresses the problems being created by the weak capitalization of the international banking system, without the extreme moral hazard problem associated with TARP-style over-paying for bad assets.  The financial intermediation function performed by banks is crucial to the efficient functioning of the economy and, for a number of reasons, undercapitalized banks do not perform this function well. Understanding this, the approach of govenments everywhere has been to use taxpayers money to prop up undercapitalized banks. But while banks play a crucial role that doesn’t mean that we necessarily need the current set of banks to perform this role.

Kevin already posted a link to Willem Buiter proposing something like this but the idea is now being given wider prominence. Here for instance is a nice clearly-written piece from today’s Wall Street Journal by Stanford’s Paul Romer.  An important benefit of this type of plan, as Romer notes, is that it seems more likely to attract additional private sector equity capital relative to the various plans to attract new investors for existing banks with failed management and murky balance sheets. Indeed, I first read about the idea of new banks in this 2009 predictions piece from celebrity uber-bear bank analyst Meredith Whitney and she was focusing purely on the private sector opportunities. She said:  “I think you’ll see more new banks created. We’ve already seen more applications. And it’s a great idea: You start with a clean balance sheet and make loans today with today’s information. Plus, right now you’ve got a yield curve that’s good for lending.”

Skeptics could point out that these new banks will lack the branch network or knowledge capital of existing banks.  However, branch networks could be purchased pretty cheaply these days and the newly-minted banks could be attractive places for those bankers with good track records to work. Perhaps the best argument against this idea is the time lags involved in getting new banks set up. But the problems in the international banking system seem likely to be with us for some time so useful long-term solutions may be called for.

No doubt I’m being wide-eyed and innocent here.  Perhaps our trusty band of loyal commenters can give me a word to the wise.

Irish bond spreads

I was idly looking for patterns in the daily evolution of eurozone government bond spreads (like you do) and thought I would share some findings. The spread of Irish Government bonds over the 10-year German benchmark have of course trended upward during the period since early September 2008 to last week:

If we compute principal components of the spreads of ten euro-currencies we can try to isolate the different factors: separating factors that affect all countries from those that affect Ireland in relative isolation.

Using daily changes in the spreads, the first three principal components explain 80% of the total variation in the ten series.

All ten bonds have roughly equal loadings on the first PC (which alone explains 62%). We can therefore think of PC1 as measuring fluctuations in general aversion to credit risk.

PC2 seems to measure a component which is irrelevant to Ireland — from the loadings this one looks like Club Med vs the North.

But PC3 is an almost Ireland-specific factor, much smaller loadings on the other countries. The big action in PC3 is on just three almost consecutive days in January: the 16th (Anglo nationalization), 19th and 21st.

To me this illustrates just how easily spooked this particular market is. Anglo nationalization was not even demonstrably bad news. When will it settle down to a realistic assessment of Irish risks?


The linear regression equation explaining changes in the Irish spread in terms of three principal components is (t-stats in parentheses):

ΔIreland = 0.020 + 0.015 PC1 + 0.042 PC3 + 0.024 PC4
(17.7) (32.7) (32.0) (15.6)
RSQ=0.958 DW=2.16

The constant term reflects the general upward trend in Ireland’s spread (which is not explainable by this method).

(Of course there are many methodological tricks one could explore, but it’s getting late and this seems enough for the present. Probably some readers do this stuff for a living!)

Back to the banks

The policy pendulum looks set to swing back to dealing with credit flow in the banking system.  With so many policy proposals floating around internationally, I would be very interested to hear current views on the best policy course for the government. 

 Taking it as given that there has been a severe contraction of new credit, how much is due to: (i) a collapse in the demand for credit as firms and households repair balance sheets; or (ii) a collapse in the supply of credit?  

 Under (ii), is the main reason for the decline in supply: (a) the declining creditworthiness of potential borrowers; or (b) the risk aversion of bankers as they teeter on the edge of insolvency?

 It seems to me that if the contraction is mainly driven by some combination of (i) and (ii a), the government would be wise to limit the additional fiscal commitment.   A large package would further tighten the fiscal solvency constraint and force a more rapid fiscal correction. 

 The case for a large package seems more compelling if the credit contraction is being driven by the caution of the bankers.   Whatever the size of the package, what is the proper balance between re-capitalisation, insurance for new credit flows, troubled asset purchases, etc? 

Balance Sheets

Brian Lucey and Constantin Gurdgiev write in today’s Irish Times about the scale of debt liabilities for various sectors in the Irish economy and illustrate that Irish firms and households have high levels of debt relative to international standards: you can read their contribution here.

A useful complement to their analysis is to examine the balance sheet statements for the various sectors, since the sustainability of debt depends on asset levels and the dynamics of asset valuations (major asset declines in 2008!). The CSO has made considerable progress in recent years in producing estimates of balance sheets for each sector in Ireland: you can read the latest report here and download the data here.