updated 2.12.2018
(Introduction)
[1] An online survey that I am doing (https://goo.gl/forms/PZd5CbbRZuknmnbJ2) shows the majority considered interest rate to be the domain of the Federal Reserve Bank/Central Bank and/or selected banks. Interest rates are a creature of policies by a Central Bank (usually independent) and used as a benchmark rate to profit by licensed banks in the formal money market system known as the inter-bank rate where banks lend funds to each other without security (based on trust). This inter-bank rate is determined by several banks amongst themselves involving no outsiders. Howsoever rates are conceived, they have dual purposes — an indicator of costs of funds and default risk. During the last financial crisis in 2008, U.S. Federal Reserve and other Central Banks were monitoring Libor in different currencies to see how successful their latest policy announcements were in calming the markets. Even governments were looking at individual banks’ submissions for clues as to their risk exposure. This circular feedback can be problematic as we found out later. It should be noted that U.S Federal Reserve in April 2018 through the Alternative Reference Rate Committee (“ARRC”), a group of big banks had introduced Secured Overnight Financing Rate “SOFR” to work along and later to replace Dollar Libor. This was in part a direct response to the Financial Conduct Authority’s (UK) announcement in July 2017 that the LIBOR system will be phased out by 2021. The “SOFR” is a broad measure of the cost of borrowing cash overnight through Treasury securities and is based on real transactions between banks only (transactions with U.S Federal Reserve are excluded). Currently in the US, there are two main rates, one being policy driven -Federal Reserve Funds Rate, the other by consensual bankers — Inter-Bank Rate and lately “SOFR”. Given the mostly bank-centric rates, this paper argues for a need for a transactional based “Third Rate” to check whether the two main rates are realistic or fair or competitive or even biased. First, a fair rate must be transparent and while “SOFR” is based on real transactions it is not transparent nor is it competitive (its parties are still banks). While the U.S Federal Reserve usually provide their meeting-notes (after several months later), the regular commercial banks do publish their rates accessible online without any guidance. For example for loans, using postcode 90210, the average borrower will pay rates at 4.87% (APR for 30 Years) with the lowest at 4.55% and the highest at 5.287%. Even with ARM 3–1, we get an offer range from 4.851% to 5.22% (for refinancing), both within tight ranges suggesting no bank wanted to be an outlier and the borrowers are given more of the same within a ballpark of 0.4% range for comparison (https://www.bankrate.com/mortgage.aspx?type=newmortgage&propertyvalue=362500&loan=316800&perc=20&prods=1,2&fico=740&points=Zero&zipcode=90210&vet=NoMilitaryService&valoan=false&vad=false&fthb=false). Obviously different borrowers will have their own contracted rates depending on the amount, term, location and income (I am currently inviting users to www.bankguru.com to share their actual rates and payments for loans to check and measure the quality and degree of fairness. Please support this effort to answer the important question of being fairly charged for borrowing privilege). In comparison, using the same postcode again, on the deposit side (or lending to banks), for Certificate of Deposits “CD” for 1 Year the highest was 2.7 % with the lowest at 0.01% effectively a much wider range while for 5 years the highest APR is 3.3% and lowest is 0.15% as at 13 Oct 2018. (https://www.bankrate.com/cd.aspx). The wide range reflected individual banks’ appetite, at the high end ready to compete on the quantum and liquidity, these are published rates and not necessarily transaction rates. These rates are usually lower to reflect the costs in aggregating them. At the time of writing 25 Oct 2018, the Federal Reserve’s rate is at 2.25%, the Inter-bank rate is 2.51% , Libor (3 months) at 2.5% (https://tradingeconomics.com/united-states/interbank-rate) and SOFR 2.19% (over-night) (https://apps.newyorkfed.org/markets/autorates/sofr).
(Rates are fair?)
[2] Using the banks’ published loan rates we can deduce that the banks are non-competitive amongst themselves. For example, it is obvious no matter which bank we ask for a loan, there isn’t much difference after considering application fees and others given the marginal difference to be within range of 0.4%. This non-compete is not reflected on the deposit side. Here the rates’ range is much wider suggesting a market awash in cash and different appetite for deposits. In the U.S and in most countries, CD are guaranteed up to $250,000 per account holder in response to banking debacles. It is noteworthy since modern banking started over 400 years ago, banks have been dictating the terms of deposit-taking to their clients. Effectively, this means the bank “borrower” decides when deposits are needed, how to use the deposits and on terms that leave depositors with a binary option. May we posit in the 21st century, depositors have earned their right to self-determine their own terms or even to limit how their funds can be applied (say not for marijuana business)? This self-determination to negotiate is our loosely proposed “Third Rate” between retail based depositors with banks. It is not to compete but rather to manage this “intermediary” business in a meaningful way on both side of their books. The main reason is because banks are structured to answer to their shareholders only even sometimes at the expenses of their clients. Their clients have been silent over the years even when they had lost their savings (in Savings & Loans crisis 1980s and 1990s “S&L”) or when their tax dollars were used to bail delinquent banks (after 2008) or in the UK public funds used to purchase the Royal Bank of Scotland (“RBS”) which failure was in part as spectacular as its rising. In May 2018, RBS settled with Department of Justice (“DOJ”) paying fines of $US 4.9 Billion. (https://www.enca.com/money/royal-bank-of-scotland-to-pay-49bn-us-subprime-fine) for its role in the sub-prime fiasco. The DOJ settlement follows a separate fine of $US 5.5-billion that RBS agreed in July 2017 with the Federal Housing Finance Agency over the same matter. To better understand why it is time to democratise banking, we must first revisit how the biggest market in the world works and failed in the past.
(What are “deposits”?)
[3] Deposits are funds held by a bank pays interest (or “profit” in Islamic financing) but imposes the requirement of notice (or a penalty in terms of interest) before a withdrawal can be effected; a deposit receipt is an acknowledgment by the bank that sums have been deposited and are being held for the account of the depositor; a certificate of deposit is a financial instrument providing a similar acknowledgment but where said claim of the depositor is transferable on demand. Once deposited each dollar are put to work. In “It’s a Wonderful Life”, the film’s most famous depiction of banking, George Bailey said “The money’s not here”. “Your money’s in Joe’s house — that’s right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others.” Traditionally, banks take deposits and invest them in loans, make them useful as “intermediary” as they put funds to create new assets or values as opposed for purchasing existing assets. This distinction is critical to explain how the latter can lead to a bubble-bust cycle while the former leads to measurable economic activities known as “GDP”. Other than generating tax payable, there is no GDP generated by merely buying and selling of commercial papers. Banks mainly profit by the interest paid to depositors after netting payments from borrowers. Banks will add a risk premium for different categories of borrowers on top. The modern banks do more than just “intermediary” for example they also create bearer products like bonds carrying a higher risk. Banks are also involved from securitization to market making, to opportunistic speculation and looking after clients’ money for a fee where sometimes they are in conflicting positions (according to the movie “The Big Short”). In some countries where negative interest rate prevails, the depositors have to pay the bank for this privilege. Between themselves, banks hold a monopoly over everything about finance, money, and derivatives as such.
(Where are the banks today?)
[4] The banks’ role in society has been unchanged and is underpinned by the regulation creating formidable barriers to entry. However, in the last 20 years, starts-up as they were then like Paypal, Venmo and recently Square are seen to be taking on the transactional businesses of the banks. More recently newer technology such as Artificial Intelligence (“AI”), crypto-currencies and decentralized database like Block-Chain entering into the fray. These startups are under-cutting costs using state-of-the-art information technology (as opposed to legacy systems) and advanced analytics to profile their users by answering online social needs like user to user payment. The real break-through is in providing identifiers like emails instead of bank account numbers using the internet as the gateway to pay instead of walking into a bank and waiting 2–3 days. Conversely, in the last 40 years, banks have been in the news for all the wrong reasons from S&L to bringing down the House of Barings, sub-prime fiasco, Libor/rate rigging and in 2018, Australia through its continuing Banking Inquiry saw financial institutions charging fees for non-service. Even deceased’s accounts were not spared. Of course the mother of all banking disaster is still being unravelled involving a young Malaysian embezzling more than US$ 4.5 billion from a Malaysian Sovereign Fund named 1MDB by coercing the weakest links in several banks to launder the money. Some wrongs are currently being prosecuted by the Dept of Justice in the U.S which has progressed from civil to criminal charges. (see https://www.bloomberg.com/news/articles/2018-05-24/how-malaysia-s-1mdb-scandal-shook-the-financial-world-quicktake). Unfortunately, there is little motivation to change and fines seem to be the cure for all the banks’ “troubles”. For example, despite running RBS down and almost broke the UK’s banking system, its CEO and board members never saw the inside of any Court at all. In fact despite agreeing to one the biggest fines recently, the UK government is celebrating by off-loading its RBS-shares as RBS just made its first profit in 2018.
(Are banks prone to repeating scandals?)
[5] For most ordinary folks, the Libor scandal in UK (and affected US markets) is nothing more than just a piece of fleeting news as compared to the financial melt-down 10 years ago followed by high profile Senate investigations. In part most do not understand that in reality rate rigging affected their mortgages for higher payments and lower rates for deposits. According to the authors at https://en.wikipedia.org/wiki/Libor_scandal, and I quote “Because Libor is used in US derivatives markets, an attempt to manipulate Libor is an attempt to manipulate US derivatives markets, and thus a violation of American law. Since mortgages, student loans, financial derivatives, and other financial products often rely on Libor as a reference rate, the manipulation of submissions used to calculate those rates can have significant negative effects on consumers and financial markets worldwide.” The Libor scandal was slightly different. The motivation for low-balling Libor was not tied to profit — many banks actually stood to lose out from lower Libor. This was about survival as they needed the cheap funds for their balance sheet when credit was drying up. However only 1 person (Tom Hayes, former UBS Trader) went to jail for 11 years in 2016 after confessing that he knew it was wrong and profited for his ex-employer. This is how Tom Hayes put it “But the point is, you are greedy, you want every little bit of money that you can possibly get because, like I say, that is how you are judged, that is your performance metric.” (https://www.theguardian.com/business/2017/jan/18/libor-scandal-the-bankers-who-fixed-the-worlds-most-important-number). Other than a well-crafted report known as “Wheatley Review” produced in 2012 which was adopted later in 2013 by the British government, not much has been done to address the greed and the fraudulent mechanics as opposed to reforming the institutions on paper. Given Libor’s tattered reputation as mentioned earlier Dollar Libor will be phased out by 2021. A possible replacement “SOFR” is already up and running in the U.S from April this year. You may think this is unfair as the bulk of actors even got to keep their severance or obscene bonuses as seen in the RBS fiasco. However, the banks’ lawyers insisted there is a distinction between manipulation and theft, the latter meant jail term. This is despite the banks knew or sanctioned such manipulation as early as 1991.
(Aftermath of the Libor Scandal)
[6] London not New York is the epi-center for the benchmark Libor which is basically a group of banks getting together to decide on the Offer Rate for offering USD outside of the United States on unsecured basis. Despite the big fines with the highest levied at Deutsche Bank for USD 2.5 Billion and increased monitoring, and change of administration to NYSE Euronext Rates Administration Limited, an entity under the supervising of UK’s Financial Conduct Authority. To calculate the Libor rate today, a representative panel of global banks will submit an estimate of their borrowing costs to the Thomson Reuters data collection service each morning at 11:00 a.m. The calculation agent throws out the highest and lowest 25 percent of submissions and then averages the remaining rates to determine Libor. Calculated for five different currencies — the U.S. dollar, the Euro, the British pound sterling, the Japanese yen, and the Swiss franc — at seven different maturity lengths from overnight to one year, Libor is the most relied upon global benchmark for short-term interest rates. The rate for each currency is set by panels of between eleven and eighteen banks. (https://www.cfr.org/backgrounder/understanding-libor-scandal). It was also decided that new contracts, however, may use either Libor or a transaction-based benchmark rate. (https://www.bloomberg.com/news/articles/2013-05-13/wheatley-seeks-dual-track-libor-as-gensler-says-replace-rate). As part of the settlement for Barclays Bank, it was ordered to base its submissions on market prices rather than some hazy estimate of borrowing costs which is probably the most significant improvement to date (see page 32 under heading Determination of Submissions and I quote “Barclays’ transactions shall be given the greatest weight in determining its Submissions, subject to applying appropriate Adjustments and Considerations in order to reflect the market measured by the Benchmark Interest Rate. “ at https://www.cftc.gov/sites/default/files/idc/groups/public/@lrenforcementactions/documents/legalpleading/enfbarclaysorder062712.pdf). Regrettably only Barclays was ordered out of the 11 to 17 banks that still persist on using the estimation method. According to the authors in exposing the flaws and I quote “The big flaw in Libor was that it relied on banks to tell the truth but encouraged them to lie.” (see https://www.theguardian.com/business/2017/jan/18/libor-scandal-the-bankers-who-fixed-the-worlds-most-important-number)
(The unseen hand of banking)
[7] While China’s major banks are state-owned, in London there is a place where banking influences are peddled and traded openly. For example, Libor is still operated by banks within the City of London which is managed by Corporation of the City of London, an entity that made its own rules dating back to medieval times. Almost exclusively run by the banks, the Corporation of the City of London has its own unelected parliamentarian (known as “Remembrance”) and is an independent “county” within the United Kingdom with an area as large and known as the “Square Mile”. Journalist George Monbiot described this Square Mile and I quote “The City of London is the only part of Britain over which parliament has no authority.” and further quoting others “Shaxson shows how the absence of proper regulation in London allowed American banks to evade the rules set by their own government. AIG’s wild trading might have taken place in the US, but the unit responsible was regulated in the City. Lehman Brothers couldn’t get legal approval for its off-balance sheet transactions in Wall Street, so it used a London law firm instead.” and concluding “Its power also helps to explain why regulation of the banks is scarcely better than it was before the crash, why there are no effective curbs on executive pay and bonuses and why successive governments fail to act against the UK’s dependent tax havens “. ( https://www.theguardian.com/commentisfree/2011/oct/31/corporation-london-city-medieval) .
(Across the Atlantic)
[8] The Corporation of the City of London has only one equal competitor across the Atlantic in New York known as “Wall Street”. US banks together with the U.S Federal Reserve Bank apply interest rates to manage the US economy funded in US Dollars. The U.S Federal Reserve Bank’s mandate is to ensure its policy can deliver within the parameters of its dual inflation rate/employment. This is done through the Federal Open Market Committee (“FOMC”) which stood for maximum employment while keeping the inflation rate close to 2%. In layman terms, this translates to more monetary accommodation will lead to less unemployment; however, beyond this illusive point of longer-run sustainable unemployment, it will also lead to an accelerating inflation rate that is higher than 2%. It is difficult to manage in practice because the expectation of future figures of the unemployment and the inflation rates are beyond mere mortals, these measurements can also be highly uncertain and require seasonal adjustments leaving decisional gaps. In the past, this task was accomplished by using a crystal ball to predict the near future accurately backed by after-thoughts but nowadays we have a new tool known as Artificial Intelligence or AI. But even AI needs data. It is, for this reason, we are planting the seed for the “Third Rate” as another indicator (on top of employment and inflation figures) to aid in delivery of U.S. Federal Reserve’s mandate. Done transparently, this will give the FOMC a powerful “spotlight” into how the retail interest rate markets are transacting in real-time in particular to gap those time when said employment and inflationary figures are still in production. Using retail transactions between depositors to banks would be far better than banks to banks transactions as in the newly “SOFR” or existing Libor or Inter-Bank Rate. Given this “Third Rate” originated from an auction platform as opposed to market matching, its open transparency would make it difficult for third parties to manipulate the U.S Federal Reserve. This is important to bring confidence to the money market which is still hazy to many outside of the banking establishments.
(Inter-Bank Rates are meaningless while Deposits are more prominent as source of funding)
[9] Even with an auction mechanism on the “Third Rate” platform to engage the banks, this is not to say the banks are totally impotent. They as a group would still have the greatest influence over deposit rates because of their licensed deposit-taking monopoly. Whether the banks will compete is very much an issue of appetite now. “Third Rate” allowed depositors to engage with banks in price discovery under a competitive auction platform where deposits are offered based on depositors’ terms. Banks also borrow from other banks, via the inter-bank rate where they lend and borrow unsecured between each other. Looking back at the height of the credit crisis in 2008, the inter-bank lending rate was meaningless as no bank will lend to another without collateral and none were trusted to have any collateral as fellow banks do not know the extent of each other exposure (particularly after Bear Stearns’ collapsed). Having learn that painful lessons, banks became reluctant to lend on an unsecured basis. Subsequently with the market awash with cash and the rise of deposits as can seen in this graph below the reliance on inter-bank loans became insignificant (https://www.moneyandbanking.com/commentary/2018/3/4/bank-financing-the-disappearance-of-interbank-lending). The Table below shows in US fraction of assets of domestically-chartered commercial banks funded by interbank loans and by deposits (Percent), 1990–2017
[9A] In contrast given the take-up of deposit funding over the years after 2008 as seen above, applying this “Third Rate” platform would be more persuasive as a predictive tool than the newly created replacement for Dollar Libor or “SOFR” for “FMOC”. Since 2008 banks can also refer the costs of borrowing (from depositors) to the Federal Reserve where they are mandated to maintain liquid funds which previously were interest-free. This means after 2008, at least in the US, banks are incentivized to take deposits and depositors are more confident as deposit insurance are now in all US jurisdiction. With the availability of this “Third Rate” as another funding platform, this may assist the U.S Federal Reserve should another credit crisis come ahead. The U.S. Federal Reserve also takes deposits being the banker of banks from both Financial Institutions (Interest on Excess Reserves-IOER) and non-Financial Institutions but at a lower interest rate (Overnight Reverse Repurchase Agreements- ON-RRP). The noted difference between the two is that IOER has a higher rate but unsecured while ON-RRP is secured but lower rate.
(Who are the likely depositors?)
[10] Firstly, most young people (“millenniums”) may not have enough saved after education loans. Some may have crypto-currencies but even this is speculative as not many are assumed to be technologically savvy. Further millenniums are more inclined to borrow than to save. The next groups are likely to have committed to their first property with a mortgage leaving small amount to put aside for a rainy day. This would vary between 1–10% of their gross income and be split between equities and deposits. Already burdened by a mortgage, they are more concerned about the lending rates than deposit rates. Be that as it may, that leaves two more groups, those who are retirees and those who run huge pensions fund. Again for the sake of argument, retirees would be more vulnerable as every investment they had in the past is now converted to cash so they can afford to pay for their growing list of expenses. It is a fact that older people will probably incur more medical expenses or related bills, even before factoring rising costs (consequences of rising rates). Even if it is not in liquid form, such instruments say government bonds will be attached to some fixed income stream dependent on the interest rate. It is also worthwhile to comment that the size of their wealth will also depend on when they cash out. This means the most likely depositors will be pension funds or those with large cash positions wanting to maximise their returns at short notices with maturity up to a year or less.
(Case for competitive and fair rates)
[11] For those of us who have reached our mid-life, there is an urgent need to ensure our limited savings will last to sustain a comfortable life in later years. While one can execute the best financial plans, but one can’t predict the timing of events like “market crashing” although “October” seems to be the favourite. Further, it is beyond us to plan our future medical expenses unless we do not plan to be sick at all. Instead of worrying about the unknown future, here we have this “Third Rate” platform getting better returns for our deposits or savings. But this have to be done together as a syndication. As I mentioned in the beginning, in most cases depositors presumed the published rate offered by the banks are fixed. This is obviously not true. For years, High Net Worth Individuals (‘HNWI’) have been able to negotiate better rates from their private banker with no strings attached. This show banks are flexible to accommodate their wealthy clients. The difficulty is that most of us have tiny accounts in comparison. With my proposal for the “Third Rate”, depositors could syndicate their deposits together into a larger account. The proposed platform will include software instructions to group the depositors’ amount with the same maturity period. This may assist depositors to get a better rate but not necessarily better service as compare to genuine HNWI.
(Alternatively, do banks really need your money ?)
[12] Another view is that modern banks do not lend out deposits on a dollar per dollar basis. They create “money” by the demand of credit from worthy borrowers for loans out of thin air and your deposits money are put as reserve with the Federal Reserve to buffer any inter-payments between banks. This is the view by the Bank of England at page 14 of Quarterly Bulletin 2014 Q1 in its overview and I quote “In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.” This is also known as the “fountain pen money” method at page 16 of Quarterly Bulletin 2014 Q1 (https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf?la=en&hash=9A8788FD44A62D8BB927123544205CE476E01654).
[13] There is no reason to doubt the Bank of England. And where the banks create deposits by the ‘fountain pen money’, the ‘money’ will be destroyed only when it is applied to pay off the debt owned by the borrower. In a mortgage, the buyer borrows and ‘fountain pen money’ is deposited in his account only to be transferred to another bank to pay off the seller, so it is destroyed. In this scenario, the borrower’s bank whose newly created ‘deposit’ is now transferred to seller’s account, borrower’s bank will need to get additional deposits (read your money) to maintain its practices to lend using ‘fountain pen money’. Notwithstanding the dollar in dollar out ratio, this still means the bank will try to attract more deposits at a higher rate where it wants to further lend to ‘worthy’ borrowers. But ultimately it is the willingness of borrowers (either in business or personal) wanting to borrow that will influence the creation of credit and indirectly the volatility of deposit’s rate. With this proposed “Third Rate” platform, potential borrowers will be able to consider a loan rate auction as well, although this may be unlikely given as we have stated earlier; banks have an non-competitive preference on the loan side.
(Conclusion)
[14] We suggest given the further reliance on deposits as a funding tool since 2008, this is where this proposed “Third Rate” platform is the solution to engage with the banks to procure transparency and competitiveness. It is also the only platform to collate the depositors’ funds by syndication providing another source of funding. An auction system is preferred even though deposit “money” is fungible, but the quantity, maturity and the minimum rate may be different between depositors. The allowance to have a minimum rate made it clear to the banks that the depositors will have the final say and for first time in 400 years a bilateral arrangement is formalized. Cumulatively, the rates created through various auctions are determinable in real time. This “Third Rate” being the only retail rate between depositors with banks based on transactions for a range of maturities from one month to 1 year. This “Third Rate” could also be used to dampen an overheated economy as it is likely to strike a higher deposit rate first through the market pre-empting the U.S Federal Reserve’s move.
(Disclosure: I did not include any discussion on the effect between Bid/Ask spread. In practice this would be wider when the market is volatile. I am also the inventor of the “Third Rate” platform — US Patent 7376612)
