The terms “HQLA” and “LCR” may be a bit wonky for the
typical investor, but given the effects of these terms as they have been
recently placed in banking regulations, they are important.
Interest rates are extremely important. They affect
the value of almost every financial asset including stocks. It has long been
acknowledged that short term interest rates can be influenced, if not
controlled by the Federal Reserve and other Central Banks. But, up until
recently, it was assumed that Central Banks could not affect longer term
interest rates---the assumption was that “market forces” of supply and demand
would determine long term interest rates.
Even Central Banks and many famous economists have
been puzzled and frustrated to some extent by the fact that falling interest
rates since the 2009 financial crisis have not resulted in more economic
expansion and growth.
The economic “law” of supply and demand has not been
repealed. Interest rates are low because the price buyers are willing to pay
for a given unit of debt obligation is high.
If a “buyer-lender” or “investor” is willing to pay $100 for the promise
from a debtor to pay $4.00 per year in interest, the interest rate is 4%. If however, buyer-lenders bid up the “price”
to $400 for the same promise of $4.00 per year in interest, the interest rate
is only 1%. The only way that the price
can go from $100 to $400 is for there to be increased demand and/or decreased
supply for interest payments. So where is this increasing demand coming from?
For a while, the Federal Reserve itself became a
buyer-lender with the introduction of Quantitative Easing. They bought Government Debt with IOU's created "out of thin air". But continued QE was
politically unpopular. So the massive
increase in demand created by QE is coming to an end, at least in the US.
To replace it, a more politically acceptable way to
increase demand for the interest payments from the government was devised
through implementation of regulations to “insure the financial stability of
banks”. These regulations were recently
finalized with minimum standards for LCR or “Liquidity Coverage Ratio”. (Rules
approved September 3, requiring 80% compliance by 1/1/2015 and full compliance
by 2017.) The Liquidity Coverage Ratio regulations indicate that banks are
required to have a certain level of holdings defined as HQLA or “High Quality
Liquid Assets”. The most acceptable form
of debt meeting the definition for HQLA?
You guessed it….Government Debt.
A recent Bloomberg article indicates banks have added
$180 Billion to their now historically high government debt holdings this year.
One estimate indicates that Bank of America alone will have to add $65 Billion
to their government debt holdings in the future to become fully compliant with
the new regulations.
Insuring the safety of bank deposits by requiring banks
to buy government debt tends to produce low interest rates but it does not
encourage any expansion in business activity. Increased savings by the public
increases bank deposits and ramps up the requirement for banks to hold even
more government debt.
To reverse this trend, given the current regulations,
the public will need to borrow more and save less. Borrowing more is unlikely because again,
consistent with well intentioned goal of financial stability, lending standards
have been tightened. Saving less is also
unlikely because people are so uncertain about the future.
Lowering interest rates as an economic policy has long
been compared to pushing on a string. Economic expansion will require a
dramatic change in the global population’s expectations regarding future
economic opportunity and prosperity.
So on one hand, the government has been stimulating
the economy…but on another hand it has been implementing policies to restrict
credit…policies that restrain economic expansion.
Despite the probability that the Fed may raise short
term interest rates in 2015, keep in mind that regulations to “insure the
financial stability of banks” were put into place not just in the US, but
around the world—particularly in Europe.
Interest rates in Europe and Japan are considerably lower than in the
US.
Unless we see a substantial increase in “animal
spirits” leading to both increased borrowing (hopefully for productive activity)
and/or decreased savings, it is very possible that we will have low interest
rates for a long time. (Animal spirits is an economic term referring
to people’s willingness to take risks because of an expected future economic
boom.) Of course, in such a low interest rate scenario, without such "animal spirits" we will have many banks where most of the depositor’s money is simply lent to
the government. This is a recipe for
economic stagnation.
A far out possibility is that depositors tire of low
interest rates and begin seeking alternatives to placing their money with banks
subject to the LCR regulations--in other words with "investments" NOT subject to the LCR regs. We have actually seen a bit of this….increased
demand and rising prices for dividend paying stocks.
Rising interest rates will only occur because of
increased supply of interest payments (more borrowing) from borrowers and/or
decreased demand for them (less lending/saving). (This is a bit counter-intuitive as popular opinion seems to assume
that interest rates are low because banks are not lending. Interest rates are
low because demand for interest payments from the largest borrowers, namely
governments, is increasing.) $4 of annual interest would no longer fetch a
price of $400. The price would need to fall perhaps back to the historical
average of $100. (4% per year interest rate.)
One wonders whether the regulators considered that possibility as one
can only imagine the economic effects if the value of HQLA held by banks declined
significantly.
Keep in mind, more borrowing might be not because of “animal
spirits” and increased productive activity, but rather because of increased
borrowing by governments. Given the current situation with Social Security and
Medicare, that is a distinct possibility.
So am I making a prediction? No I am, not. There is a high probability
that interest rates will stay low for longer than many expect. But there is also a possibility that interest
rates could rise significantly. What I
am warning about is a high degree of uncertainty regarding interest rates. And,
where there is high uncertainty, caution is usually warranted.
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