Forced de-banking

AML compliance in the US is imposing a lot of harm on people mistakenly suspected of moneylaundering. 

The New York Times provides a few worrying examples. The algorithm flags something, and accounts go poof. 

Bryan Delaney has owned several New York City bars over the decades, and he and his business partner and general manager, Jennifer Maslanka, have a longstanding system for handling cash: It goes to the bank on Fridays and Mondays.

As card use has increased over the years, the size of the deposits has decreased. To make the accounting easier on new staff who started working during the pandemic, Mr. Delaney and Ms. Maslanka often rounded deposits down to the nearest thousand and kept the rest of the cash on hand to make change.

This year, Chase closed the bar’s account, plus personal checking and credit-card accounts for Mr. Delaney, his wife and Ms. Maslanka, giving them a handful of weeks to make other banking arrangements.

Federal law requires depositors to fill out a form if they’re depositing or withdrawing more than $10,000 in cash. Sometimes, in an attempt to avoid the gaze of the authorities, account holders will engage in “structuring,” making a series of transactions just under $10,000. It’s one of the top reasons that banks file suspicious activity reports.

Mr. Dubrowski, the JPMorgan Chase spokesman, said the bar’s series of deposits was indeed the problem.

“We must know our customers and monitor the transactions that flow through our bank,” he said. “That includes instances where we see a pattern of cash deposits that are just below federal currency reporting thresholds.”

Mr. Delaney said he had not been engaged in structuring when depositing money in round numbers. All the cash had come from the bars, he said, and he reported his income and paid his taxes as he was supposed to.

The bank’s explanation is especially maddening, given that he and Ms. Maslanka had filled out plenty of the $10,000 forms over the years. “What’s to gain from not filling it out?” he said. “What’s the risk of filling it out? I’ve done both when deposits warranted that.”

“I’m still so confused,” Ms. Maslanka said. “Do you think I’m part of some underground Mafia, laundering money through my little beer bar?”

I wonder how common this is in NZ. 

Richard Meade on banking and competition

Prudential regulation requires banks to hold more capital than they would otherwise like to, so that there's less risk of default and less risk that the bank imposes bailout risk. 

New Zealand does not have deposit insurance, but some are of the view that there's an implicit guarantee of at least some sort - that the government would not let depositors be too badly hurt. The open-banking resolution mechanism would impose haircuts on depositors if there were still a shortfall after unsecured creditors and equity were burned through, and I don't think anybody really knows how big a haircut might prove politically intolerable. In that view, deposit insurance then just winds up requiring up-front payment for the insurance they're probably already getting for free. 

In any case, high capital requirements mean that banks have to hold a lot of capital; they have to compete for that capital against other potential uses of it. So you'll wind up with high nominal reported profits. And politicians will then point to high profit levels as reason for windfall taxes and the like, while ignoring return on equity. 

Those big numbers generate political demand to do things. And so it seems near-certain that the Minister of Commerce is going to ask ComCom to run a market study on the banks.

Over at The Conversation, Richard Meade raises a few points that need to be kept in mind:

• The OCR sets a coordination point for pricing that could be considered price-fixing in other sectors; 
• RBNZ's cheap wholesale funding during the worst part of Covid reduced the risk of meltdowns while preserving bank profitability;
• RBNZ restrictions on entry, aimed at ensuring financial stability, also prevent competition.

He concludes with a few questions:

First, are growing bank profits due to banks acting anti-competitively, the Reserve Bank fighting inflation and preserving financial stability, or both?

Second, if bank profits are indeed excessive and due to anti-competitive behaviour, are there measures the commission could recommend and practically implement that would improve outcomes?

Finally, if bank profits are excessive, and at least partly due to the Reserve Bank doing its job, would interventions by the commission to improve competition worsen financial stability or frustrate the fight against inflation?

Answering these questions will need both the commission and the Reserve Bank to have serious conversations about how competition policy and banking regulation can be made to work together to achieve better outcomes for both bank customers and the wider economy. Little would be gained by improving bank competition if that reduces financial stability or worsens inflation.

I still think that a market study focused on barriers to entry, including account portability, could do some good. 

And I still think that that will not be what the Minister of Commerce asks for. I expect instead that the Minister wants show-trials of bank executives during the election campaign, during which they can be harangued just as the supermarket CEs were during that market study, with any report coming after the election. That kind of market study would focus on interest rate margins, mortgage interest rates and the like. 

The point would be to make it easier for the government to blame the banks, rather than bad government policy, for poor outcomes during the election - while trusting that ComCom wouldn't issue any final report until after the election. 

And the risk would be a whipping up of appetites for very bad policy and rash promises during an election campaign. The draft supermarkets report was poorly done, and created an anchor point for populist expectations - and for legislation.

If I'm right, I hope that ComCom is able to push back on any weak terms of reference and propose something that could add value rather than do harm. 

And for a bit more on New Zealand's monetary policy mess, Bryce Wilkinson's report, out today, is a must-read. 

Tilting at bank profits

RBNZ Chief Economist Paul Conway wants a ComCom market study into banking. He's worried about 'profiteering'.

But this is the first time the Reserve Bank, which is statutorily tasked with regulating banks, has stepped in so explicitly. It's been warning of "profiteering" in some sectors during the cost of living crisis and in the aftermath of Cyclone Gabrielle, and singled out the widening gap between mortgage and term deposit rates.

"It's a very legitimate thing for the central bank to be concerned about and to be keeping an eye on," Conway says. "It's a general warning across the New Zealand economy that now is not the time for profiteering. Now is actually the time to start paying the price, for climate change and, in this instance, for the cyclone."

Commerce Minister Dr Duncan Webb says no decisions have yet been made about the focus of the next market study. "However, I am focused on using the tool to ensure markets operate fairly for consumers," he tells Newsroom. "I am particularly interested in improving markets where the greatest long term gains can be made for ordinary New Zealanders."

I've also thought a market study into banking, and insurance, could be well warranted - but with a very different focus.

I've worried that barriers to entry look awfully high and that we may be missing out on innovations happening overseas as consequence. 

Last year I'd urged that ComCom change how it does market studies. Rather than a giant draft study that tries, and inevitably fails, to estimate weighted cost of capital and potential excess returns, start with a desk-based analysis of barriers to entry. 

Because whatever you wind up doing will depend on barriers to entry anyway.

Suppose that you really strongly believe that there are high excess profits in whatever sector. If you're right, what's stopping anyone from coming in and eating away at those profits? Remember that profits are a signal that tells other to enter. If they aren't entering, is it because you're wrong about your guess on excess profits? Or is it because there are regulatory, legislative, or other barriers preventing entry? 

When ComCom thought there were excess profits in supermarkets, and I was yelling about barriers to entry, some folks argued for KiwiGrocer as cartel-busting parallel to KiwiBank. But now we're talking about banks, and KiwiBank's already there as KiwiBank. And for whatever reason, it seems far less profitable than other banks. Surely that should give some pause.

Now banks wouldn't be the first place I'd be aiming a market study: medical services really should be first in line. But barriers to entry in banking and insurance are obvious things to look at. 

But man it's a worry if the RBNZ is wanting the thing aimed at 'profiteering'. If that's the kind of advice the Minister's getting, then expect a request for a very different market study. Instead of looking at barriers to entry, it'll be more like the Supermarkets draft study - where they raked the CEs over the coals for weeks and tied up supermarket exec teams for months in inquiries. 

If that's the request that ComCom winds up getting, then it's a test of ComCom. 

Do they indulge the Minister's preference for a highly politicised and populist bash on the banks in an election year? Or do they do the work that actually needs doing: checking whether barriers to entry, including the nonsense that RBNZ layers on top of the industry, and CCCFA regs, make for less competition than would be desirable?

Heck, RBNZ is undertaking an investigation into whether it should make it even harder for foreign banks to operate here. And Paul Conway's pointing fingers at banks for profiteering.

Jonathan has a few bits from me in his piece. It'll ungate tomorrow if you pull the /pro from the URL. But the bit including my quotes is here:

Dr Eric Crampton, chief economist at the NZ Initiative think tank, says the appropriate use of a market study would be to ascertain what barriers there are to new entrants to this country's banking market. 

New Zealand has been a slow follower on structural changes like open banking, and such easy wins as account number portability. When phone number portability was introduced in this country's cellphone market, it played a critical role in breaking apart the Telecom-Clear duopoly.

It's expected bank account portability would make it easier for bank customers to move their money (or their debt) to more a competitive bank.

What all this means is it can be difficult for a new player to get a toehold in banking here, Crampton says. "In groceries, the Commerce Commission found zoning and consenting proved substantial barriers preventing entry. In building materials, the commission’s draft study pointed to substantial barriers to using foreign-sourced building materials. In both cases, easing barriers to entry would improve competition," Crampton says.

"If the Commerce Minister told the commission to look at barriers to entry in banking, or in insurance, that could be worthwhile. The combination of barriers to entry and regulatory measures like the Credit Contracts and Consumer Finance Act may have had substantial detrimental effects on competition.

"If so, it would be great to document the barriers, their effects, and how those barriers could be eased. Is New Zealand seeing the same innovations in FinTech and InsuranceTech as are being seen overseas? Could a foreign online financial service provider easily enter the New Zealand market, or would it be impossibly hard given our scale? What are the effects on consumers?

"But I would greatly worry that, in an election year, a minister could be tempted to send the commission off on more populist tilts against the banks," he says. "Sending the commission off to interrogate the banks about interest rates and mortgage rates would be politically tempting and help divert attention from the prior government failures that led to rising rates. I would also hope that the commission would push back against proposed studies that would shed a lot more political heat than provide actual light."

It would be exceptionally disappointing if ComCom got put to populist electoral purpose this year.  

Morning Roundup

The tabs...

• Australia considering changes in governance at the Reserve Bank, including setting a Monetary Policy Committee. Hope that they avoid the errors NZ made around unqualified Board members and ruling out monetary policy expertise on the Monetary Policy Committee.
• Regulations shifting toward open banking are coming. It seems in-principle a good idea.
• Vic Uni's Martien Lubberink with some cautions about attempts to tax bank profits.
• The government's delaying biofuel mandates. That's great, but better would be abolishing them. When tech and carbon prices make them a cost-effective way of mitigating emissions, fuel companies will pick them up to avoid paying for carbon permits. National says it would scrap any mandate - good!
• Jem Traylen at BusinessDesk points to a path through on Three Waters; includes a bit from me on revenue bonds. 
• Canada playing silly buggers with tariff-rate quotas under CPTPP to freeze out NZ dairy. It's going to arbitration. 
• Oliver Hartwich on collapsing education results. 
• Michael Reddell on RBNZ Governor appointments. Bottom line: better to find a Governor that has respect from all the main parties rather than either a short-term extension or reappointing the one who hasn't got it. 
• Geoff Mortlock on Orr's reappointment.
• Immigration NZ's computer systems remain a mess so the backlog in visa approvals gets worse. If that can't be fixed in a hurry, why not just ditch the rule banning non-residents from buying houses so that living here as a non-resident is less bad?

Morning roundup

The morning's worthies. 

R₀ on tabs is high. 

• Matt Nolan provides a coherent critique of the government's unemployment insurance scheme from the left. Simon Chapple suggests leveraging off KiwiSaver for short-term consumption smoothing.


• The MoH advice was to end MIQ back in November. I would have disagreed with that advice. But it's interesting because those of us pitching ways of strengthening safety while enabling more travel were always cast as death merchants by those wanting to canonise Bloomfield.


• They told us that there are no slippery slopes. Now they want a new advertising code of ethics "to end the promotion of high-carbon lifestyles and products." It is barking mad, and it has Julie Anne Genter's support. 


• Against genetic denialism


• The odds of an inflation disaster are rising.


• The negative supply shock worsens.


• Richard Prebble is right. The Reserve Bank of New Zealand cannot be trusted under its current mandate.


• Oregon's legalisation of psilocybin therapy ... it's going to be an expensive trip.


• Fairly large investment in solar generation coming for NZ. Remember that NZ's able to make this work without subsidising solar. Just taxes on carbon and a so-far clean electricity market. 


• Last week, David Clark was threatening the supermarkets. This week, Grant Robertson did at the post-Cabinet briefing - check the 16:30 mark where he notes they're still considering going further than the ComCom recommendations - like "separation of some of the entities involved". Robertson wanted inflation, or didn't care about stopping it. And now he needs a scapegoat. 


• ProdComm put out a report last week encouraging fixing NZ's dumb bans on genetic engineering. Reporting has been positive (RNZ, Newsroom, BusinessDesk). Fingers crossed. 


• Thomas Coughlan works through the timeline on MoH "consolidating" RATs.


• The new Transmission Pricing Methodology aims to remove first-mover disadvantage by only charging a transmission customer for the capital cost of the capacity that they need, not the full capacity that gets built when a new bigger line is put in. Effectively that will mean that the lines company bears the risk if it overestimates follow-on demand. They're probably better placed to bear that risk. 


• Peter Griffin on fintech developments in NZ. I'm going to have to catch up on this stuff.

Bankers aren't farmers

On Radio New Zealand this morning, Andrew Little argued the government should lean on the banks to prevent their foreclosing on dairy farms, warning of that foreigners might swoop in and buy distressed NZ farms. 

A few things to consider:

• Banks do not want to run farms. If they foreclose, they have to find somebody to run the thing pending auction. There are cows that need to be fed. The bank or the receiver takes on all the health & safety, and animal welfare, liability. The most heavily leveraged ones are the ones that'd be first to go; those are the ones where the banks have the biggest stake, and where the banks would take the greatest share of the loss in a fire-sale. A receiver's fees will include all the farm-running costs.
• If the bank lets the farmer continue, restructuring payments over a longer period, then the bank does not have to run the farm. Banks are only going to foreclose as a last resort. You could even imagine their wanting to delay foreclosure until selling prices improved. 
• In Little's nightmare scenario, some rich foreigner comes up to the bank and says "Hey, I'll pay you last year's price for that there farm if you foreclose on it." But that foreign buyer has to jump through a lengthy overseas investment act process if he wants to buy. The foreign buyer has no assurance and can have no assurance as to what the current, and potentially aggrieved, owner will do with the darned thing in the period between the OIA process beginning and the foreclosure. 
• If I were a bank and I feared that a future Labour government might make it hard for me to foreclose on mortgages held by politically preferred groups, I'd be adjusting my loan portfolio today to guard against that risk. 

I wonder if Donald Trump has yet started warning his rallies about how the Mexicans are going to come in and buy all the farms. "Protecting American farms for good American farmers. We need a wall to keep rich Mexican drug-lords from coming in and buying America's land."

Update: Now Little wants regulations dictating pass-through of RBNZ headline rates to retail interest rates.

Banking tradeoffs

Suppose that you were a libertarian who had to decide between two banks.

The first one is privately owned and seems happy to provide to the police pretty much any information about your finances that the police might ask for, without a warrant. It has updated its privacy policy since then, though it won't disclose just what that policy is.

The second one is owned by the government but has been told off for failing to comply with anti money-laundering regulations. If the police asked them for data, maybe they wouldn't be able to find it. 

Doesn't seem that hard a choice, really.

Apologies for the hiatus. Last week brought the launch of our newest report, and a fair bit of follow-up work. Posts on that to follow, and your regularly scheduled service soon to resume.

Update: nobody really comes out well in New Zealand, where deference to the police is pretty ingrained - as Rodney Hide points out in today's print NBR. 

Open Banking Resolution and Deposit Insurance

New Zealand's Open Banking Resolution system in case of bank failure makes bank failure less likely, and so makes depositor bailouts less likely, but doesn't eliminate the risk that the government might bail out depositors.

Matt Nolan has made this point more than a few times and has urged that we reinstate deposit insurance and require banks to pay for this implicit insurance; I hope instead that the RBNZ and government will find ways of making more credible that the depositors may be burned. If depositors bear risk, then they have to pay a bit more attention to where they put their money and, in doing so, encourage the banks to be more sensible. Further, the simple existence of OBR with a set sequence in case of failure should reduce the panic that pressures governments into bailouts. But if we can't make it credible, then Nolan may be right. 

Toby Fiennes, RBNZ Head of Prudential Supervision, laid it out in a speech yesterday. 

So OBR is about keeping a bank open and providing the government with real alternatives to liquidation or full taxpayer bailout – both of which may be totally unpalatable. It facilitates a rapid and orderly resolution of a bank failure. It does so without changing our basic legal framework around ranking of creditors in a wind-up or insolvency. In particular:

– It does not change the fact that depositors’ and other creditors’ funds are at risk. It is a well-established legal principle that people stand to lose money if a business that owes them money cannot meet all its obligations. Banks are the same as any other business in this regard.

– It does not change the ranking of creditors. Shareholders will be the first to lose their investment. Once shareholder funds are exhausted, subordinated creditors bear losses, followed by all other unsecured creditors on a pari passu basis, meaning that those with an equal legal claim get equal treatment. This is the same as in a liquidation.

Two features of OBR make it particularly well-suited to the principles for crisis resolution I outlined earlier. They are:

– Its flexibility. OBR deals with the immediate crisis, including payments and liquidity issues around failing banks, without closing off long-term solutions.

– It reduces moral hazard. Bank shareholders, management and investors know that in the case of bank failure the authorities have a viable option that would put their stakes at risk. The mere presence of OBR in the toolkit will impact expectations of government support.

Fiennes continues:

It is important to emphasise that OBR and deposit insurance are not in any way alternatives. OBR is also applicable in a world where we have deposit insurance as in one where we don't. Deposit insurance usually involves the establishment of an insurance fund, to which banks contribute. There are many different variations on, and within, that basic framework, but OBR can cope with all of them. For example, if there’s an insurance fund, the fund itself could stand as a creditor in the OBR. This is how the FDIC (the US deposit insurer) is treated in failed US banks.

New Zealand does not currently have any form of deposit insurance or deposit guarantee. This position was confirmed by the Minister of Finance in 2011 (http://www.beehive.govt.nz/release/maintaining-confidence-financial-system). There are three reasons for this position:

– Deposit insurance is not always effective in preventing bank runs by retail depositors. UK-based Northern Rock suffered a classic retail run in 2007, despite a deposit insurance scheme being in place.

– Deposit insurance is hard to price accurately and fairly; and brings with it difficult boundary issues. Should it be just for banks – as is currently the case for OBR – or should it also include finance companies, building societies and credit unions? How would we ensure that the least risky banks do not end up subsidising the more risky?

– Deposit insurance will increase moral hazard, making the banks more susceptible to failure, which brings with it the need for more, costly regulation.He also notes that a large bank's failure could easily overwhelm a deposit insurance scheme and that the costs of deposit insurance in encouraging bad bank behaviour outweigh the benefits of avoiding depositor losses. So even in Nolan's world where the government cannot credibly commit not to bailout, the inefficiency caused by the certainty of a bailout (rather than the weighted expectation of one) can be large enough to make the scheme undesirable, even if the government does wind up bailing out the banks.

As I'm not a banking guy, here are a few things I particularly do not know much about and would materially affect the ability of OBR to reduce bailout risk:

• The proportion of secured versus unsecured bank liabilities. If there isn't much that can be burned through before hitting depositor assets, then the haircut landing on depositors would be greater and so too would be the political pressure for a bailout. 
• How easy it would be for banks to shift away from unsecured liabilities, knowing that risks put on depositors make bailouts more likely.
• Bank ownership structures. The NZ banks are owned by big Oz banks that have an implicit Oz government guarantee that's actually worked into their Fitch credit ratings (as best I understand things). Suppose something bad happens and one of the Oz banks and its NZ subsidiary both are going down. Do we know what assets are really with the NZ subsidiary and which are with the Oz parent? Will there be incentive to restructure the equity profile depending on which side of the ditch is looking stronger? Can they tunnel equity back to the Oz parent in the NZ subsidiary is looking dodgy and so leave less to burn through in OBR? RBNZ runs some strong prudential regulation; I'm sure they're on top of this stuff. I just don't know anything about it.

The greater the proportion of the burden borne by bank shareholders and unsecured creditors other than depositors, the lower I'd expect to be the pressure for bailouts. If deposit holders are to take a ten percent haircut if bad things happen, I doubt that they could muster nearly as much bailout sympathy as depositors facing a fifty percent haircut. 

Fiennes concludes:

But there’s always the remote possibility that a bank does get into trouble, at some point. If that happens there are no simple solutions. It will be messy, people will lose money and how it is dealt with will depend on circumstances at the time.

OBR is a tool that gives government an additional option to taxpayer bailout or liquidation. It is not the only option that will be available on the day. Its mere existence provides important incentives for bank shareholders and management to minimise the risk of failure.

New Zealand does not currently have deposit insurance, for reasons that are more to do with moral hazard and the sheer difficulties of defining boundaries and pricing than consumer protection. We believe it is better to keep the risk of failure very low, including through a strong regulatory framework, than to build structures that can distort incentives and behaviour.

If, however, deposit insurance were to be introduced, it could easily be accommodated within our toolkit of OBR and other crisis measures. It is not a case of choosing between one or the other – they have different objectives and can work alongside one another if need be.

We have to distinguish between best-case deposit insurance and achievable deposit insurance. How well you think the government can price the bank's underlying riskiness and how well the political system can ensure fair actuarial rates rather than implicit subsidisation of riskier banks will matter in your evaluation of deposit insurance's desirability. But note too that the world in which the government is really good at assessing bank's risks is also the world in which prudential regulation likely works well. I lean towards staying out of deposit insurance, but I'm not hugely confident in my point estimate here - as I noted earlier, I'm not a banking guy and really don't have enough information to be very confident.

Update: I failed in copying the second bit of Fiennes's speech the first go-round. My computer was trying very hard to crash while I was posting.

Fractional reserve banking

Bryan's post at EconLog critiquing Rothbard on fractional reserve banking is entirely correct.

And it brings back memories of the Rothbard Graduate Seminar that I attended in the summer of '99 in Auburn. I pressed a couple of the folks there: if we were in a free banking system and people chose, with full knowledge, to use deposit accounts that paid interest in exchange for the bank being able to lend that money out to others, we could hardly call the arrangement fraudulent. The answer I'd then received, if I recall correctly, was that such an arrangement was fine, but it shouldn't be called banking.

I'd be pretty surprised if the nominal change resulted in less confusion. Jimmy Stewart reminded folks pretty well how banking as we now know it works.


And the Simpsons reminded us a bit more recently.

In praise of foreign banks

Matt Nolan writes in praise of foreign banks.

On the surface there appears to be a lot in common with the Irish, Greek, and NZ economies. All three have high net foreign liability positions, liabilities are highly concentrated through banks who are borrowing overseas, all three have experienced some form of housing boom and lift in consumption, and finally all three appeared to have a relatively strong fiscal position before the GFC before moving into fiscal deficits after the shock. And yet (so far) while the Irish and Greek economies and banking systems have collapsed, New Zealand’s has been fine.

There are two major differences that have helped reduce the implied risk on our debt, making New Zealand much less likely to experience a bank run:

1. Our banking system is primarily foreign owned,
2. We have a freely floating exchange rate – combined with having much of our debt denominated in NZ$ this is useful.

This is an important point to recognise. While many commentators are saying we should “peg” our dollar and set up more domestic ownership of banks GIVEN the risks associated with the GFC, I tend to reach the opposite conclusion – namely, the reason why we haven’t suffered as much as these countries as been largely the result of our free floating exchange rate and the fact that a larger economy has a large stake in our banking system.

Agreed.

We're far more robust to shocks to the domestic economy than we would be if our banks' asset base were heavily New Zealand oriented. The Aussie parents are hardly likely to let their NZ branches fall over in the case of a liquidity problem here. But the NZ branches are operationally separate, subject to local prudential regulation, and hold reserves in New Zealand; if the Australian property market collapses, it would be very tough for an Aussie parent bank to lean on the New Zealand branch for assistance.

Systemic shocks and correlated risks are bad things for banks. Why would a small country ever want to rely primarily on "Local banks for local people"? Yeah, there are lots of systemic risks against which we can't insure easily. But that's no reason to try to make things worse.

Perhaps America should encourage Canadian banks to set up branches in the States....