The price of safety

One of the key factors of the financial crisis was the failure of safe assets and as the financial system looks for ways to create more havens, Tomas Hirst and Frances Coppola ask what is the driver behind such a desire for safety

Much attention has recently been focused on the shortage of safe assets in the financial system. There have been proposals for creation of a larger supply of safe assets through issuance of more government debt or changing the tenor of government debt from long- to short-term since the shadow banking system uses short-term government debt as collateral.

One idea that has been mooted is that the problem is not so much a shortage of safe assets as reduced velocity of collateral owing to safe asset hoarding. There have also been many suggestions that the financial system should create more of its own safe assets and stop expecting government to backstop it all the time. And there is evidence that the financial system is already finding ways of circumventing tighter collateral rules through collateral transformation services, thus undermining the direction of regulation particularly of riskier activities such as over the counter derivatives trading.

But so far no-one is asking why the financial system needs safe assets in such quantities. What exactly is the driver behind such a desire for safety?

It is unfair to blame regulation alone for the increased demand for safe assets. All regulation has done is sharpen an existing need. Nor is it fair to say that the increased demand is solely due to risk aversion following the 2007/08 financial crisis – investors were seeking safety as a primary objective long before that. In fact one of the key factors in the financial crisis was the failure of safe assets.

Residential mortgage-backed securities, widely used in the shadow banking system as safe assets to back cash deposits, suddenly became unsafe as the extent of subprime defaults emerged: when BNP Paribas announced that it could not price mortgage-backed commercial paper following the failure of the Bear Sterns hedge funds in August 2007, institutional investors pulled their deposits and the ABCP funding market collapsed. Similarly, in 2008 the fall of Bear Sterns itself and later of Lehman caused runs on tri-party repo, a supposedly safe collateralised form of funding. Safety, it seems, was critical, and when safety was removed, so was the money.

This is vital to an understanding not only of the 2007/08 financial crisis but of the shadow banking system and financial crises in general. It is often stated that the cause of the credit bubble and subsequent crash was “search for yield” – lots of hot money flowing around the world seeking a return. That is true, but it is not the whole story. The first, and most important thing that the hot money flows were seeking was safety. Investors were looking first of all to avoid loss. The search for yield was secondary.

Avoiding loss is the key driver of all depository activity, whether in the regulated banking system or outside it. Investors making cash deposits do not expect to take losses. This is as true of cash-rich corporations and high net worth individuals as it is of small retail depositors. The problem is that large deposits in the regulated banking system are not insured. So large-scale depositors look for liquid investments outside the regulated banking system that carry some form of guarantee or safe collateral backing. Short-term government debt is the best, but prior to the financial crisis property-backed private label assets were also regarded as good collateral. When those failed in the financial crisis that left a crippling shortage of safe collateral. The temporary lifting of the FDIC insurance limit mitigated this by enabling insured bank deposit accounts to be used by wholesale depositors (e.g. companies). But that limit has now been re-imposed and yet there still is no sufficient replacement for the private-label safe assets lost in the financial crisis and the sovereign ones lost in the eurozone crisis.

The question is whether avoiding loss is a reasonable expectation for a wholesale depositor – or indeed a retail one – and more importantly, whether governments should be expected to make good all losses suffered by depositors. Deposit insurance schemes explicitly commit government to making good the losses of small depositors. Some people suggest that only transaction accounts should receive such a guarantee, and that other small retail deposits should not be guaranteed: but deposit insurance helps to prevent retail depositor panics and bank runs, and there may also be good social reasons for protecting small savers from loss. But wholesale depositors are perhaps a different matter.

Typical losses suffered by depositors are default (where the depository institution is unable to return their money) and capital erosion owing to negative real interest rates (where inflation is higher than the nominal rate of interest on the deposit). For retail depositors, the first of these is mitigated through deposit insurance and the second may be mitigated by indexed rates. Similarly, for wholesale depositors the first of these is mitigated through investing in safe assets and the second by investing in index-linked assets.

However there is a third type of loss that both retail and wholesale depositors seek to avoid, and that is taxation. Retail depositors avoid taxation by putting funds into pensions and other forms of tax-free saving such as the Isa. The equivalent for wholesale depositors is taking funds offshore and/or transforming them into assets that are more lightly taxed. That is what the shadow banking system does.

“No one is asking why the financial system needs safe assets in such quantities”

At present there is considerable concern around the world about tax avoidance. There are calls for closure of tax loopholes, elimination of tax avoidance schemes and clampdown on tax havens. This is driven by considerable public anger about what is seen as “unfair” behaviour by large corporations and rich individuals. The tax avoidance about which there is so much anger is perfectly legal and arises as a direct consequence of liberal tax regimes, open borders and free movement of capital. The question is therefore one of morality: is it “right” for wealthy individuals and large corporations to seek to avoid tax by perfectly legal means?

Tax campaigners have a point: corporates using the shadow banking system to avoid taxes while taking advantage of government guarantees on debt are looking to have their cake and eat it. But from the point of view of the wholesale depositors, avoiding taxes is perfectly reasonable. Retail depositors, after all, are able to save free of tax: why should not wholesale depositors? And since tax havens provide a legal means for them to do so, why should they not use them?

There are some practical reasons why governments might wish to offer retail depositors more loss protection than wholesale ones, but the moral case for this is still to be made, and until it is, it seems wrong to regard wholesale depositors as “immoral” for seeking the same loss protection as retail depositors.

So companies seek to deprive government (legally) of tax income. But, by investing in government debt they are returning money to government even if they are not paying tax – money that can be productively used for investment in the real economy.

Admittedly government has to pay interest on that debt, but that is the only cost, and it could be very low or even zero. So what is the problem? Why is tax avoidance such an issue, if government debt is the vehicle in which the “hidden” deposits are primarily invested? Surely an alternative to the difficult job of chasing tax avoiders all around the world would be simply for governments to issue more debt and encourage those tax avoiders to buy it? Admittedly, if government spent the money it raised from so much additional debt it would risk inflation, but it could always raise interest rates and/or increase taxes to choke it off. What is not to like?

Sadly this strategy falls foul of the problem of how do government assets remain safe? In the eyes of investors, government assets only remain safe if they can be guaranteed to be repaid in the future – which means, ideally, holding cash backing for them (risk-free) and/or running fiscal surpluses sufficient to meet all future debt service and refinancing obligations. Running persistent fiscal surpluses, unless accompanied by trade surpluses, destroys the private sector’s ability to save, eventually wrecking both investment in the real economy and ordinary people’s security. And cash backing for government debt prevents money raised through debt issuance from being invested productively in the economy. The consequence of large wholesale depositors’ desire for safety is therefore progressive impoverishment of smaller depositors and indeed of the whole economy. This could be offset by taxation of wholesale deposits, but not if those wholesale deposits have been hidden somewhere they cannot be taxed.

Alternatively, government could simply ignore investors’ demands for debt to be kept safe, and do whatever is necessary to meet the needs of their economies. After all, sovereign currency-issuing governments do not actually have to issue debt at all. They do so in order to make it possible for the private sector to save in something other than currency. If large wholesale depositors abuse that facility, governments can simply refuse to make it available to them. But the problem is that issuing large amounts of debt without considering the effect on price and interest rates potentially impedes the ability of the government (via its central bank) to control inflation.

What we really need to do is reframe the whole issue. A sovereign currency-issuing government does not require debt in order to fund spending, and it does not require taxation either. Debt is a savings scheme. And taxation is a means of mopping up the excess of government spending over production, thus reducing the risk of inflation – the same job as interest rates do on the monetary policy side. The real problem is investment, not taxation.

This point is all the more crucial considering the impact the financial crisis has had on private sector investment. As a recent Ernst & Young ITEM Club report stated:

“Growth in UK business investment remains modest compared with previous recoveries. It grew by 5.1% in the year to the third quarter of 2012, reaching £31.5 billon. This is 13.6% higher than the trough seen in Q4 2009, though 11.6% lower than the peak of Q4 2007…Since the financial crisis, UK businesses have reduced capital investment much more than those in Germany, France and the US. While this has been in part supported by the UK’s flexible labour market, it could impact capacity in the longer term. It is now vital to evaluate investment plans to ensure sufficient productive capacity of the right type to meet the growth in demand forecast for 2014-15.”

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The collapse in business investment has been accompanied by a sharp increase in cash reserves held on company balance sheets. In the second quarter of last year private non-financial companies were sitting on about £730bn in currency or on deposit.

A number of theories have been put forward to explain this phenomenon. Some have suggested that the build up of cash reserves reflects a lack of easy access to credit or corporates building up a war chest for when demand begins to recovery. However, in its Green Budget the Institute for Fiscal Studies suggested an alternative possibility (emphasis mine):

“Anecdotal evidence suggests that small firms continue to report problems accessing finance, which may go some way to explaining the poor performance. However, it does not appear that financing problems are the decisive factor; investment is typically dominated by large firms, which have good access to external funding, both from banks and from other sources, and have also accumulated large cash surpluses in recent years. Rather, the slow recovery in business investment appears to be more related to fragile business confidence.”

The IFS points in particular to three major potential threats to the global economy: eurozone sovereign debt crisis, the US ‘fiscal cliff’ and the possibility of a Chinese hard landing.

Given the potential for a serious macroeconomic shock it is perhaps unsurprising that corporates would could to start building up capital buffers. From an investor’s perspective it might simply look like sensible risk management with the additional benefit that some of this cash could ultimately be channelled into increased dividend payouts to shareholders.

“There is no doubt that corporate balance sheets are looking the strongest they have been for many years,” says Graham Ashby, head of UK equities at Ignis Asset Management. “My conclusion is that if they cannot find any use for the cash they should be looking to pay it back to shareholders or invest in organic growth.”

‘Companies tend to have more cash when they have more debts’

As Ashby implicitly suggests hoarding cash is not a costless activity. A study by Cass Business School and Credit Suisse last year suggested firms that keep excess cash on their balance sheets are punished by markets to the tune of 9 per cent over three years, adjusted to a market index.

If the recent suit filed by the US fund manager David Einhorn against Apple for its “depression-era mentality” in building up £87bn of reserves is successful then it could also leave cash-heavy firms open to a wave of litigation from shareholders.

The big question then is not why companies are building up their reserves but why they are struggling to find productive uses for them. Respondents to Ernst & Young’s October Global Capital Confidence Barometer survey reported a sharply increased preference to use excess cash in order to pay down debt and a marked reduction in investment in organic investment.

If true, it suggests more difficult times ahead for the economy. Holding back investment delays the uptake of new technology, ignores opportunities for business expansion and potentially damages productivity in the long run. That is hardly ideal particularly given the fact that the UK is already suffering falls in productivity over the past few years despite an apparent improvement in the labour market.

However, Andrew Smithers, a leading expert on financial economics and head of Smithers & Co, says that much of the increase in capital reserves can be traced to an upswing in corporate debt since the onset of the crisis.

“The data from the Office of National Statistics show that debt is high, compared to output or assets, whether measured gross of net of cash type assets.Bonds are raised and repaid in lumps. Individual companies therefore tend to have high cash balances when they have just borrowed or are just about to repay debt. On average therefore companies will tend to have more cash when they have more debts,” he says.

“The main reason for raising debt is to buy back equity. The reason for buying back equity is it raises managements’ bonuses. Companies are not investing because management is paid not to. Investment would probably be depressed today by fears of low growth, but the main reason not to invest is that is what management is paid to do and they do it! Additional evidence lies in the way forecasters have been disappointed by investment, productivity and inflation.”

That the Global Capital Confidence Barometer does not appear to demonstrate this trend is unsurprising – any suggestion of imminent share buybacks would only drive up share prices of cash rich companies making them more expensive. Nevertheless in 2011 buybacks were equal to about 3 per cent of GDP.

Ashby agrees that investors need to look closely at the behaviour of management:

“There are still a number of companies in which management are remunerated on an earnings-per-share basis that they can boost through buybacks. The question that needs to be asked is: are they paying a sensible price for the shares?”

Although the thesis is an interesting one, short-term management remuneration alone does not seem to be a sufficient explanation for what we are seeing. If management are forcing up returns on equity through share buybacks in order to bloat their remuneration packages then it speaks more of pessimism over the prospects for profitability than a mark of confidence.

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The build up of debt over the past few years can be traced to ultra-low interest rates by central banks that have allowed firms to borrow extremely cheaply. While this additional capital can be used to buy back shares or boost dividend payments it also represents a liability, especially if interest rates begin to creep up.

Central banks have signalled their intention to hold rates at current levels for as long as it takes to spur a recovery. Unfortunately this may become a self-fulfilling prophecy. Debt-laden companies have an incentive to hold back investment in order to prevent an economic recovery that could drive up the costs of refinancing themselves.

Moreover, although this policy may work in the short term a stagnant economy where real incomes and productivity are falling points to a difficult outlook for corporate profitability.

Although the overall profitability of UK companies appears to have held up relatively well over the crisis manufacturing profits have contracted sharply while profits in the services sector have crept up. This tells us either that services have been able to bleed their existing assets more efficiently than manufacturers or that companies have been gleaning addition profit by leaning on their suppliers.

Whichever is the case, it hardly amounts to the great trade rebalancing that economists were hoping for and without productive investment in their businesses overall profitability in all sectors is likely to decline.

Yet the chief executives of many of these same companies are among the leading voices in calling for the government to cut deficit spending. Despite the long shadow that shifting deficit reduction targets are casting over domestic demand, the corporate consensus has remained firm on this point.

It is unreasonable of the private sector to withhold risky investment in potentially productive activities themselves and refuse to allow government to do so. If private investors will not take risks, and the government cannot for fear of upsetting private investors, the economy is doomed to stagnation. So it appears that companies have three choices:

1) They can allow governments to meet their need for safe assets, but accept that governments will use the money raised from the additional debt to invest productively in the economy.

2) They can invest their deposits productively themselves, taking risks in order to generate economic growth to the benefit of everyone including themselves – and perhaps governments might offer some tax incentives for this.

3) They can allow government to invest productively on their behalf using money they return to government through taxation.

Or they could go for some combination of all three, of course. And on its side, government needs to consider the extent of loss protection it can or should reasonably offer to both wholesale and retail depositors. Current direction of policy appears to discriminate against wholesale depositors in favour of retail, while keeping the back door open for wholesale depositors to find less obvious ways of obtaining similar protection.

It is not acceptable for risk-shy corporates to dictate terms to governments regarding the conduct of economic policy while withholding essential investment and expecting the sovereign to compensate them for losses. Nor is it necessary or desirable for government to encourage hoarding of unproductive assets by offering sovereign loss-protection insurance of one kind or another to all investors.

For there to be a growing and productive society, someone has to take risks – and if the private sector will not, they should either be slapped in the face as the economist David Beckworth suggests, or government should take the risks instead. The quest for safety ultimately leads to economic death.