When Banks Pay Borrowers’s Mortgage Interest, Europe Edition

Falling interest rates in Europe have put some banks in an interesting position: owing money on loans to borrowers.The Wall Street Journal reports on the curiosity:

At least one Spanish bank, Bankinter SA, the country’s seventh-largest lender by market value, has been paying some customers interest on mortgages by deducting that amount from the principal the borrower owes.

The problem is just one of many challenges caused by interest rates falling below zero, known as a negative interest rate. All over Europe, banks are being compelled to rebuild computer programs, update legal documents and redo spreadsheets to account for negative rates.

Interest rates have been falling sharply, in some cases into negative territory, since the European Central Bank last year introduced measures meant to spur the economy in the eurozone, including cutting its own deposit rate. The ECB in March also launched a bond-buying program, driving down yields on eurozone debt in hopes of fostering lending.

So in Spain, Portugal, and Italy, the base interest rate used for many loans, especially mortgages, is the euro interbank offered rate, or Euribor. The rate is based on how much it costs European banks to borrow from each other. Banks set interest rates on many loans as a small percentage above or below a benchmark such as Euribor. If the spread plus the Euribor is below 0, the Bank pays the borrower.

A Man Walks Into a Bank

Patrick Combs received a fake check in the mail for $95,093.35. As a joke, he went to his ATM and deposited it, thinking that it would bounce in a day or two. But it didn’t, as he describes in this great piece for The Financial Times:

But seven long days later the lottery-like amount was still there and I visited the bank where an employee told me that the funds were now all available for cash withdrawal. All $95,093.35 was mine for the taking. All I had to do was ask. Windfall money begs us to take it and run. But I restrained myself. And gave the bank another two excruciatingly long weeks to do their job, catch up with their mistake, and bounce the cheque. But at the end of three hellish weeks, during which I hourly resisted the urge to take the money and run to Mexico, where it would be worth twice as much, I was told by my branch manager, “You’re safe to start spending the money, Mr Combs. A cheque cannot bounce after 10 days. You’re protected by the law.”

So he decided to withdraw the money… What happened next was pretty interesting. The comments, however, disparage Mr. Combs:

Not funny. Mr. Coombs is a consumer ‘shoe bomber’. Because he could not restrain himself from doing something deliberately stupid, there will be endless paragraphs added to banking terms and conditions as the lawyers try to plan for every imaginable glitch in the use of atms. This kind of idiotic behaviour eventually makes life more tiresome for millions of others. Grow up.

You withdrew the money. A dishonest act. All business’s make mistakes. It would have been more amusing if you had notified them of your mistake first showing some honesty. The world can do without people like you. It moved into the area of appearing like attempted fraud on your part and not at all funny. How you bleat about them getting cross. You would have been calm of course if it had been your money?

What do you think Mr. Combs should have done? Is he deserving of the cash? Or was it a morally wrong thing to do?

Equity and the Banking System

Writing in London Review of Books, Andrew Haldane provides a brief history of banking (with emphasis on the U.K. banks) and considers the too-big-to-fail conundrum:

Consider the effects of the too-big-to-fail problem on risk-taking incentives. If banks know they will be bailed out, those holding their debt will be less likely to price the risk of failure for themselves. Debtor discipline will therefore be weakest among those institutions where society would wish it to be strongest. This encourages them to grow larger still: the leverage cycle isn’t merely repeated, but amplified. The doom loop grows larger. The biggest banks effectively benefit from a disguised, and growing, state subsidy. By my estimate, for UK banks this subsidy amounts to tens of billions of pounds per year and has often stretched to hundreds of billions. Few UK government spending departments have budgets this big. For the global banks, the subsidy can reach a trillion dollars – about eight times the annual global development budget.

We have arrived at a situation in which the ownership and control of banks is typically vested in agents representing small slivers of the balance sheet, but operating with socially sub-optimal risk-taking incentives. It is clear who the losers have been in the present crisis. But who are the beneficiaries? Short-term investors for one. More than anyone else, they benefit from a bumpy ride. If their timing is right, short-term investors can win on both the upswings (by buying) and the downswings (by short-selling) in financial prices. Bank shareholding has become increasingly short‑term over recent years. Average holding periods for US and UK banks’ shares fell from around three years in 1998 to around three months by 2008.

Bank managers have benefited too. In joint-stock banking, ownership and control are distinct. That means managers may not always do what their owners wish. They may seek to feather their own nests by making decisions that boost short-term profits and thereby justify an increase in their own pay. Such decisions may also increase banks’ vulnerability to shocks. In an attempt to avoid this problem, shareholders have sought to align managerial incentives with their own. One way of doing that, increasingly popular over the past decade, has been to remunerate managers not in cash but in equity or using equity‑based metrics. This can generate hugely powerful pecuniary incentives for managers to act in the interests of shareholders. At the peak of the boom, the wealth of the average US bank CEO increased by $24 for every $1000 created for shareholders. They earned $1 million for every 1 per cent rise in the value of their bank. But such equity-based contracts also set up some peculiar risk incentives. In the 19th century, managers monitored shareholders who monitored managers; in the 21st, managers egged on shareholders who egged on managers. The results have been entirely predictable. Before the crisis, the top five equity stakes were held by the CEOs of the following US banks: Lehman Brothers, Bear Stearns, Merrill Lynch, Morgan Stanley and Countrywide. We know how these disaster movies ended.

The evolution of banking as I have described it has satisfied the immediate demands of shareholders and managers, but has short-changed everyone else. There is a compelling case for policy intervention. The best proposals for reform are those which aim to reshape risk-taking incentives on a durable basis. Perhaps the most obvious way to tackle shareholder-led incentive problems is to increase banks’ equity capital base. This directly reduces their leverage and therefore the scale of the risks they can take. And it increases banks’ capacity to absorb losses, reducing the need for taxpayer intervention. Over the past few years, this case has been pushed by regulatory reformers. Under the so‑called Basel III agreements struck in 2010, banks’ minimum equity capital ratios will rise fivefold over the next decade, from 2 per cent to close to 10 per cent of assets for the largest global banks. That is a significant shift. Will it be enough?

 

Your Credit Score and Social Media

Well, this is slightly unnerving. In a BetaBeat post titled “As Banks Start Nosing Around Facebook and Twitter, the Wrong Friends Might Just Sink Your Credit,” we learn about a new wave of start-ups that is…

working on algorithms gathering data for banks from the web of associations on the internet known as “the social graph,” in which people are “nodes” connected to each other by “edges.” Banks are already using social media to befriend their customers, and increasingly, their customers’ friends. The specifics are still shaking out, but the gist is that eventually, social media will account for at least the tippy-top of the mountain of data banks keep on their customers.

“There is this concept of ‘birds of a feather flock together,’” said Ken Lin, CEO of the San Francisco-based credit scoring startup Credit Karma. “If you are a profitable customer for a bank, it suggests that a lot of your friends are going to be the same credit profile. So they’ll look through the social network and see if they can identify your friends online and then maybe they send more marketing to them. That definitely exists today.”

And in the last year or so, financial institutions have started exploring ways to use data from Facebook, Twitter and other networks to round out an individual borrower’s risk profile—although most entrepreneurs working on the problem say the technology is three to five years away from mainstream adoption.

Here’s what I am thinking. If you have a solid credit rating, then exposing your social media outlets could potentially hurt you. On the other hand, these algorithms may be devised such that you take a bigger hit if you don’t divulge your information. If you have a poor credit rating but a strong network of friends, then divulging your social media crumbs could help you in your overall credit score. One thing is for certain, however: if there is any way that a bank could find out more information about you to better predict your ability to repay a loan, the more aggressively it will try to implement the schema into its arsenal of judging your credit score.

We live in a brave new world.

Financial Bombshell of the Day

The details unveiled in the Bloomberg Markets Magazine piece “Secret Fed Loans Gave Banks Undisclosed $13B” are stunning. And here we thought we knew everything we knew about the 2007-2008 financial crisis. Think again:

The Federal Reserve and the big banks fought for more than two years to keep details of the largest bailout in U.S. history a secret. Now, the rest of the world can see what it was missing.

The Fed didn’t tell anyone which banks were in trouble so deep they required a combined $1.2 trillion on Dec. 5, 2008, their single neediest day. Bankers didn’t mention that they took tens of billions of dollars in emergency loans at the same time they were assuring investors their firms were healthy. And no one calculated until now that banks reaped an estimated $13 billion of income by taking advantage of the Fed’s below-market rates, Bloomberg Markets magazine reports in its January issue.

Saved by the bailout, bankers lobbied against government regulations, a job made easier by the Fed, which never disclosed the details of the rescue to lawmakers even as Congress doled out more money and debated new rules aimed at preventing the next collapse.

This statistic is just astonishing (half the value of U.S. GDP!):

The amount of money the central bank parceled out was…dwarfed the Treasury Department’s better-known $700 billion Troubled Asset Relief Program, or TARP. Add up guarantees and lending limits, and the Fed had committed $7.77 trillion as of March 2009 to rescuing the financial system, more than half the value of everything produced in the U.S. that year.

There’s a lot more quotable material here, so I suggest you read the whole thing…

Nassim Nicholas Taleb on Banker Bonuses

In today’s New York Times, Nassim Nicholas Taleb has a good op-ed decrying banker bonuses. He argues:

Instead, it’s time for a fundamental reform: Any person who works for a company that, regardless of its current financial health, would require a taxpayer-financed bailout if it failed should not get a bonus, ever. In fact, all pay at systemically important financial institutions — big banks, but also some insurance companies and even huge hedge funds — should be strictly regulated.

Critics like the Occupy Wall Street demonstrators decry the bonus system for its lack of fairness and its contribution to widening inequality. But the greater problem is that it provides an incentive to take risks. The asymmetric nature of the bonus (an incentive for success without a corresponding disincentive for failure) causes hidden risks to accumulate in the financial system and become a catalyst for disaster. This violates the fundamental rules of capitalism; Adam Smith himself was wary of the effect of limiting liability, a bedrock principle of the modern corporation.

Bonuses are particularly dangerous because they invite bankers to game the system by hiding the risks of rare and hard-to-predict but consequential blow-ups, which I have called “black swan” events. The meltdown in the United States subprime mortgage market, which set off the global financial crisis, is only the latest example of such disasters.

If you’ve never read The Black Swan, I highly recommend it. In it, Taleb goes into detail about the low-probability, high impact events that can derail individuals, institutions, and governments.

Taleb goes on to say:

What would banking look like if bonuses were eliminated? It would not be too different from what it was like when I was a bank intern in the 1980s, before the wave of deregulation that culminated in the 1999 repeal of the Glass-Steagall Act, the Depression-era law that had separated investment and commercial banking. Before then, bankers and lenders were boring “lifers.” Banking was bland and predictable; the chairman’s income was less than that of today’s junior trader. Investment banks, which paid bonuses and weren’t allowed to lend, were partnerships with skin in the game, not gamblers playing with other people’s money.

Of course, the big question is: how do we get banks to follow this no-bonus policy? Can it become a law?