Do downgrades matter?

The big economic news in the past few days has been Standard & Poor's downgrading of the credit rating of a number of European countries. France and Austria went from AAA to AA+, while Portugal's credit rating fell to the level commonly described as 'junk'.

Why does this matter? For more reasons than you'd expect.

Let's start with the most direct effect: when choosing where to put their money, investors use credit ratings as a guide. The ratings are an estimate of risk put together by analysts and researchers at a ratings agency, such as Standard & Poor's. A country with a AAA credit rating is almost certain to pay back a loan. A country with a much lower CCC rating has a good chance of not paying back, or 'defaulting', on a loan.

The whole reason investors are willing to lend money to countries is that they'll be paid interest in addition to the principal once the loan is due. How much interest an investor will demand from a borrower depends largely on the perceived risk of the loan: the reward must be proportional to the risk. It doesn't take much for an investor to be willing to lend to someone with a AAA credit rating: they're almost certain to be paid back, and any interest is basically free money. (Or if you like, compensation for not having had access to the lent money for the duration of the loan.) Countries with a AAA rating can therefore borrow at very low interest rates. If a country has a low credit rating, investors will demand a high interest rate if they're to lend it money. If they're going to gamble, the jackpot needs to be worth it.

A numerical example: suppose an investor is considering lending 10 dollars to Jack and Jill. Jill has a flawless credit rating, and the investor only asks for $1 in interest. When Jill pays him back, he'll have $11. Now suppose Jack's credit rating is so low that he has a 50% chance of going bankrupt before he can pay back the loan. How much interest does the investor need to charge so that on average he'll get the same return as he did lending to Jill? Half the time, Jack won't pay him back at all, so he'll get $0. Half the time, Jack will pay him back with interest, and the investor will get $10 + X, where X is the interest. On average, then, the investor will be paid ($10 + X)/2. To make this equal to $11, X needs to be $12. For the investor to be willing to lend to Jack when he can always lend to Jill instead, Jack must pay at least 12 times the interest Jill pays.

There, then, we have the first effect of a credit rating downgrade: the affected countries will have to pay more to borrow money. This is a very bad thing, since most of the countries involved are heavily in debt, and in a recession. During a recession, governments have all sorts of extra costs, from increased welfare and employment insurance payments to bailouts for banks. Having to pay more for loans makes it difficult to meet these responsibilities.

Countries with low credit ratings can lose out completely on some of the biggest investors, such as pension funds. Many of these funds have rules against investing in an asset below a certain credit rating. According to Wikipedia, the top 300 pension funds hold over $6 trillion (US) in assets, so that's a lot of money that's not available to countries like Portugal, with very low ratings.

An aside: for countries with their own currencies, paying their debts are not a problem, as long as the debts are denominated (that is, written in) the local currency. All the government needs to do is print enough money to cover the bill. This is not without consequences, of course. Just like flooding the market with apples lowers the price of apples, flooding the market with, say, pesos, will reduce the value of those pesos (i.e. what they can be traded for), and the country will experience inflation. The debts will be paid, though. In practice, many debts are written in terms of a foreign currency (usually U.S. dollars), or have clauses in the fine print that makes the face value of the debt go up with inflation. Countries in the euro zone face the additional problem of sharing a currency. Greece and Germany have the same currency, the euro, but while Greece would love to print more euros, prosperous Germany would be against it.


The credit downgrade of European countries can also affect European banks. This is the main mechanism by which the rating change will affect everyday citizens and businesses.

Banks run on confidence. Their job is to take money from depositors and lend it to borrowers, at interest. Any money that's sitting in the bank vault is not earning interest, and so under usual circumstances banks keep as little cash as possible on hand. If too many depositors ask for their money back at once, the bank will collapse, since most of the money is tied up in loans that take time to call in. It's the depositors' confidence that the bank is a safe place to keep their cash when they're not using it that keeps the banks going.

One of the reasons depositors have confidence in banks is that they know (or expect) that the banks are guaranteed by the government. If a bank starts to fail, the government will step in with deposit insurance or a bailout. However... if the government itself has a low credit rating and people believe it has difficulty paying its debts, they may also worry about its ability to bail out a bank. A downgrade in the credit rating of a country can therefore land that country's banks in trouble. Depositors may start pulling out, and the banks will have to pay more interest when they borrow, since they're now seen as riskier.

It's very common for banks to misjudge how much money they needed to keep in their vaults on a given day. Thankfully, there's a flourishing overnight loan market. If on a particular day a bank finds itself short of cash, they can borrow it from a bank that found it had extra cash at the end of the day. If all the banks are short of cash, then they borrow from the central bank, the lender of last resort. In most countries, the central bank can always print more money, so it's always able to provide a loan.

Starting this summer, a large number of European banks found themselves short of cash at the same time. Since they couldn't borrow from each other, they turned to the bond market. (A bond is basically a printed I.O.U. promising to pay the money back with interest at a given date.) No one was interested in buying their debt, and the banks found they had to turn to the European Central Bank (ECB) for their cash.

At first, the ECB offered to lend them money for one year at reasonable interest rates. The banks declined, saying that it would take them more than a year to collect payment from the borrowers they intended to lend the money to. That is, the ECB bill would come due before their own paycheques arrived.

In late December, the ECB repeated the offer, this time with a 3-year loan. Takeup was enthusiastic. Note that these ARE loans, not free money. Just like a regular person buying a house uses the house as collateral for the mortgage, the banks had to use whatever assets they had as collateral for their loans from the ECB. The ECB would accept the collateral at less than face value. Let's say a bank had an office building worth $100,000. The ECB might accept it for $80,000 of collateral.

Many of the assets the banks offered the ECB took the form of euro-zone bonds: IOUs issued by the governments of the euro area. When these countries received a credit downgrade, all of a sudden their debt was worth less. A 10-dollar IOU that said 'I'll pay you back $11 in three years' now was worth less than $11 due to the increased chance that the country would default on the debt (i.e. would not pay it). The amount that the ECB was willing to lend to the holders of these bonds fell with the value of the collateral.

European banks don't trust each other to pay back loans, either. Bank-to-bank lending has largely dried up, as indeed has lending to individuals and businesses. Instead of lending out the money they borrowed from the ECB, banks are putting it right back into their central bank savings accounts (central banks are the banks' banks). This is kind of silly, because the ECB charges 1.75% on its loans, and only pays 0.2% on its deposits.

To be fair, the European Banking Authority has recently asked banks to increase their capital. The banks have had to call in loans, sell off assets, retain earnings (not pay dividends to shareholders) and convert bonds into shares despite bond-holders' protests. (Whoever, in the comments, manages to explain how this bond to share conversion raises bank capital wins a prize.)

So, there you have it. This is why one agency's downgrading of European sovereign credit ratings matters. It makes it more expensive and more difficult for those countries to borrow at a time when they could really use credit, it lowers confidence in banks due to the reduced chance of a bailout and it lowers the value of existing European bonds, which can play a part in making banks less willing to lend and less able to borrow from the ECB's emergency fund.

If you're still confused or still interested, here are a few articles I found helpful in putting together this post:

Banks in Europe scrape together the extra capital they need

The ECB fills banks with funds

Why the eurozone downgrades matter

Eurozone's Friday the 13th

Which are the eurozone's zombie banks?

Consumption Smoothing Fail

Some light has been shed on the 'mystery' in the previous post. The Federal Deposit Insurance Corporation, which is in charge of exactly what it sounds like, was unable to collect insurance premiums for 10 years (1996 - 2006).

From what I can tell - the news is new to me - banks are required to pay 1.15% of deposits as premiums to the FDIC. Unfortunately, the FDIC wasn't actually given any power to collect the premiums with.

As a result, while the banks were doing well, they refused to pay the premiums, and the FDIC's holdings fell to about 0.4% of insured deposits.

Once they were no longer doing well... that was a little too late to start paying.

So, YES, given this situation, a sharp drop in the reserve ratio could very well cause a bank run with no safety net.

Also, YES, this is as silly as it sounds. As a Consumerist commenter put it, "I kind of like this logic. I mean, I've paid homeowners insurance for a good long time and it hasn't caught on fire so far--so they should just be content with the money they have collected and continue to cover my risk free of charge."

Why doesn't the fed lower the required reserve ratio?

One of my students came up with a very interesting question.

US banks are still logjammed with toxic assets, and the US government is spending a lot of money it doesn't have bailing them out.

The same government is spending yet more money on a stimulus package.

Why doesn't it kill two birds with one stone and lower the required reserve ratio? Currently, it's at 10% for a large class of liabilities. (Full details at the link.)

For non-economists: Banks are in the business of lending money, not storing it. They want to lend as much as possible, and charge interest for it. The problem is that every now and then, depositors knock on their door and ask for their money back. In cash. At once. Because of this, banks can't lend ALL the money they receive. They need to keep some in reserve. The reserve ratio is the percentage of the money they take in that they need to keep in storage, just in case. In the US, this is 10%, by law (with some exceptions, see the link). In Canada, we haven't had a legally mandated reserve ratio since 1994. Our banks keep about 4.5% reserves.

Suppose the US lowered its mandatory reserve ratio to 5%, which is still higher than the ratio that Canadian banks chose on their own. All of a sudden, banks would have a whole bunch of extra cash on hand to work with. Well, okay, so most of it wouldn't actually be cash, but the idea's the same.

Provided you believe that giving bailout money to the banks will help them, then you should also believe that allowing the banks to dip into their piggy banks should help them.

The main exception to this that I can think of is that if the drop in reserve requirements is too quick and too large, investors could panic and cause a bank run. Because banks have most of their money tied up in loans and such, they can get into trouble if everyone asks for their money back at once. Mind, this trouble is always present...

A fall in the reserve ratio works very much like an injection of money, and will tend to boost the economy in the short run. (SOMEONE is getting that unfrozen money, after all.) In the long run, it all washes out, because eventually prices adjust to the new amount of cash. The kicker is that lowering the reserve ratio also 'powers up' later injections of money - so, if what the government wants to do IS pour money into the economy for a short-term band-aid while they figure things out, and if they're willing to put up with higher prices later on, lowering the reserve ratio would help.

So, why DOESN'T the US use the reserve ratio as a policy instrument? It's run out of wiggle room with interest rates, but there's still at least 5 percentage points of reserve ratio to play with before reaching Canada's level.

Some possibilities:

1. The most convincing one: after years of being stuck at 10%, lowering the reserve ratio may trigger financial panic and bank runs.
2. Maybe the US wants to avoid higher prices in the future - this is odd, given that recently there was a fear of deflation (falling prices).
3. The US may have other plans for its monetary policy that require tighter cash.
4. The US government doesn't bother because it doesn't think it would be effective - after all, banks are logjammed for other reasons. (Though I AM of the opinion that US banks doing their best to dodge reserve requirements by turning mortgages, which probably count against reserves, into other securities that don't, are part of what got us into this mess.)

This is a very good question that I don't have a satisfactory answer two. Comments encouraged.

As for the student, he's earned himself a bonus mark.

Zimbabwe's self-destructing currency

Zimbabwe suffers from inflation of about 231 million percent a year. (Roughly, 5.5% a day.) There are many reasons for this, the most obvious being that the government keeps printing money. Like other goods, the value of money depends on the interaction of supply and demand. If the world is flooded with dollars, dollars fall in value.

The traditional first step toward slowing or stopping inflation is to stop printing money. Zimbabwe's central bank had a different idea... they'll keep the presses running, but the money will be printed with a built-in expiry date.

Very clever, even if didn't work.

Do banks create money?

(This is Tuesday's post, delayed due to midterms.)

There is a lingering belief among certain sections of the general public that the business of banks is to keep money safe. This belief is held alongside the knowledge that banks are in the business of lending money for profit. The money they lend is, in large part, that which they receive from their depositors.

The end result is that the sum of deposits is almost always greater than the sum of hard currency - banks 'expand' the money supply.

Often, this is explained as banks 'creating money' - while in some sense true, this is a very misleading description. Money is no more created by the banking system than water is created by freezing a lake. The density of water changes with heat, so that ice occupies a volume about 9% greater than the same mass of water at room temperature. While one could argue that this represents an increase in the 'amount' of water, to say water was created would be misleading.

Unfortunately, few articles take the time to explain in detail how the expansion of money works. This article, available free of charge from the Richmond Fed, is an exception. From its abstract:

"Beginning students of banking must grapple with a curious paradox: the banking system can multiply deposits on a given base of reserves yet none of its member banks can do so. Let the reserve-to-deposit ratio be, say, 20 percent and the system can, by making loans, create $5 of deposit money per dollar of reserves received. By contrast, the individual bank receiving that same dollar on deposit can lend out no more than 80 cents of it. How does one reconcile the banking system's ability to multiply loans and deposits with the individual bank's inability to do so?"

The article then explains the historical development of our understanding of the concept, and does it all with a minimum of algebra. Highly recommended reading.

Overlapping generations... of jellyfish

So there's an immortal jellyfish...

Theologians and philosophers must be having a field day. Economists? I'm worried about whether the jellyfish pension system is fully-funded or pay-as-you-go.

A fun-to-read primer on banking and finance

19th century citizens were as bewildered and dismayed by 'modern' finance as we are. Enter Walter Bagehot, man of letters and editor of The Economist, who decided to clear up the confusion by writing a down-to-earth guide on what really goes on in the money market. His classic, 'Lombard Street', is surprisingly relevant and brisk reading today. The full text is available online.

For modern audiences, I recommend the following chapters:

1. Introductory - this chapter shows how a money market, for all its faults, can be of benefit to a country. It also explains how fractional reserve banking works.

2. A general view of Lombard Street - explains how reserves are managed by the central bank and other banks. This is done for both gold-standard and unbacked, fiat currency.

5. The mode in which the value of money is settled in Lombard Street - the title says it all. This short chapter explains how the value of money is determined in a money market, and goes into detail about exactly how much power the central bank has in this regard.

6. Why Lombard Street is often very dull, and sometimes extremely excited - this chapter explains business cycle fluctuations: booms and busts, good times and recessions. All from the point of view of the money market, of course.

The rest of the (short) book, while very interesting, relies too much on the particular circumstances of the time and country in which it was written for me to be able to recommend it as general reading.