Tuesday, November 25, 2014

Bankers and Politicians: A Symbiotic Relationship

from billmoyers.com

JPMorgan Chase CEO Jamie Dimon, head of the largest bank in the United States, prepares to testify before the Senate Banking Committee about how his company recently lost more than $2 billion on risky trades. June 2012. (AP Photo/Haraz N. Ghanbari)
JPMorgan Chase CEO Jamie Dimon, head of the largest bank in the United States, prepares to testify before the Senate Banking Committee about how his company lost more than $2 billion on risky trades. June 2012. (AP Photo/Haraz N. Ghanbari)
Excerpted from The Bankers New Clothes: What’s Wrong with Banking and What to Do about It by Anat Admati and Martin Hellwig.

Although they can put in place any laws and regulations that they see fit, politicians are not in the driver’s seat in their relation with banks. Bankers know more about banking than politicians. Moreover, politicians want the bankers’ cooperation to make the investments the politicians favor — or campaign contributions. When bankers warn that capital requirements will hurt bank lending and reduce economic growth, they are rarely challenged by politicians, not only because politicians do not see through the banks’ claims but also because they do not want to upset their symbiosis with bankers.
The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It (By Anat Admati and Martin Hellwig)Bankers and politicians have a two-way dependence. In this situation, politicians can forget their responsibilities, and the political system fails to protect the economy from banking risk. Even after the financial crisis, as one politician admitted, the banks “own the place.”
The three decades leading to the financial crisis of 2007–2009 were marked by enormous growth in the financial sectors of the United States and Europe. Banks and financial firms convinced politicians and regulators that tight regulations are not needed because markets work well enough. Bankers gained prestige and wealth and their political influence increased. An anti-regulation ideology helped as well.
Prior to the financial crisis, regulators failed to set proper rules and supervisors failed to enforce the rules in place so as to prevent the reckless behavior of bankers. In the United States, for example, Alan Greenspan (chairman of the Federal Reserve), Arthur Levitt (chairman of the Securities and Exchange Commission [SEC]) and Robert Rubin (treasury secretary) prevented an initiative in 1998–2000 that would have imposed more transparency on derivatives markets. Such transparency was sorely missing in the run-up to the financial crisis. A 2004 ruling of the SEC allowed US investment banks to determine their regulatory capital on the basis of their own risk assessments, and this enabled Lehman Brothers and other investment banks to become highly indebted and vulnerable. The United Kingdom also instituted so-called light-touch regulation in order to expand its role as a major financial center.
In the United States, bankers serve on the boards of the regional Federal Reserve banks, which are in charge of supervising banks and even in setting the regulations.
An important factor underlying the financial crisis of 2007–2009 has been the failure of regulators and supervisors in the United States and in Europe to set and enforce proper rules to prevent the reckless behavior of bankers. Supervisors in the United States and Europe allowed banks to circumvent capital requirements by creating various entities that did not appear on the banks’ balance sheets. Investors were willing to lend to these entities because the sponsoring banks were providing guarantees. The supervisors did not object to banks’ keeping these exposures off their balance sheets, nor did they try to limit the banks’ obligations from the guarantees. The obligations ended up greatly weakening the sponsoring banks and bankrupting some of them when the crisis broke in the summer of 2007.
What causes regulatory capture? First, regulating and supervising an industry requires some expertise. This expertise is best found among people in the industry. Regulators and supervisors therefore tend to have significant numbers of recruits from the industry. If these people are competent, they may eventually be hired back by the industry. In such a revolving-door situation, a regulator may start out with some sympathy for the bank that he or she has just left. Also, regulators may not want to be tough on banks from which they hope to receive job offers in the future.
In the United States, bankers serve on the boards of the regional Federal Reserve banks, which are in charge of supervising banks and even in setting the regulations. For example, Jamie Dimon, CEO of JPMorgan Chase, has been on the board of the Federal Reserve Bank of New York since 2007 and will serve through 2012, even as the New York Fed is directly involved in formulating and enforcing capital regulations and other policies impacting JPMorgan Chase and other banks. This situation can create significant conflicts of interest.
Second, regulators exhibit what is known in sports as the home-team bias of referees, the subconscious sympathy of referees for the team that is cheered by the home crowd.  If the crowd of onlookers, such as segments of the press, politicians and industry specialists, favor certain people and institutions, supervisors may become biased and favor them as well. The home-team bias is particularly strong if the affected firms claim that a regulation unfairly
damages their ability to compete with away teams, firms in other countries.
Firms in the industry influence politicians and administrators by lobbying and by providing money, particularly for election campaigns. Firms in regulated industries want to make sure that appointees to regulatory positions will not be too challenging.
In this context, it is important to realize that special interests tend to be much more vocal than the general public. As regulation matters greatly to them, so they invest heavily in lobbying. To any individual without a special interest, the regulation may seem too unimportant to warrant much of an investment of attention or energy. Even if, in the aggregate proper enforcement of the regulation would be called for, because so many people are affected, special interests that fight the regulation may have much more influence.
Third, firms in the industry influence politicians and administrators by lobbying and by providing money, particularly for election campaigns. Firms in regulated industries want to make sure that appointees to regulatory positions will not be too challenging. Top bankers and politicians interact in many informal ways as well. For example, Jamie Dimon cultivates his relations with high-level government officials and has stated that JPMorgan Chase gets “a good return on the company’s ‘seventh line of business’ — government relations.” If a regulatory agency is zealous in trying to control the industry, the legislature can cut the agency’s budget to restrain the zeal.
In other industries, the effects of regulatory capture might be weakened by resistance from the firms’ clients and competitors, the public and politicians. For example, safety standards that would allow a risk of plane crashes would not be tolerated for long. The harm is evident, and it is easy to trace damage back to negligence and recklessness.
In banking, however, the damage from ineffective regulation and supervision is harder to detect. Moreover, for the reasons we discussed earlier, politicians may find it quite appropriate or convenient for regulators and supervisors to be lax toward banks. The public is dispersed and disorganized, and other individuals and firms have little to gain individually from pushing banking reform. Everyone has dealings with banks, and many find it beneficial or necessary to maintain their good relationships with the banks. In this environment, confusing and flawed arguments — the bankers’ new clothes — are more likely to affect policy. This situation can change only with significant pressure from the public. Nonprofit citizens’ and public-interest groups try to provide a counterweight to lobbying by industry groups, but their resources can hardly compete with those of the financial industry, and they often find it difficult to gain access to politicians and regulators.
Nonprofit citizens’ and public-interest groups try to provide a counterweight to lobbying by industry groups, but their resources can hardly compete with those of the financial industry, and they often find it difficult to gain access to politicians and regulators.
An interesting comparison can be made with the Japanese authorities that were in charge of supervising the Tokyo Electric Power Company (TEPCO) before the earthquake and tsunami on March 11, 2011. According to the parliamentary committee investigating the nuclear disaster at the Fukushima Daiichi Nuclear Power Plant after those events, the disaster could have been avoided if the supervisor had been more diligent in imposing safety rules and the company had been more forthcoming in complying.
In what the report on the nuclear disaster calls a “culture of complacency,” the behavior of TEPCO and its supervisors was shaped by collusive ties among the nuclear industry, regulators and politicians. Regulators allowed TEPCO to operate reactors that were known to have significant problems, and TEPCO was able to hide some problems that were even more serious. Regulations were nonexistent or inconsistent or were not enforced. The individuals involved seemed more concerned with their own interests than with the safety of the plants. The so-called nuclear power village represented revolving doors and a web of connections among government officials, regulators and TEPCO. The reports about the regulatory and political environment that emerged in the context of TEPCO show a striking similarity to the situation of the financial industry. In both cases, regulatory and political capture went unchecked, and still does, because the risks were hidden — until disaster struck.
Much is wrong with banking, and much can be done about it. If politicians and regulators fail to protect the public, they must face pressure to change course.
Anat Admati headshot (Dale Robbins)
Anat Admati is the George G.C. Parker Professor of Finance and Economics at the Graduate School of Business, Stanford University. She has written extensively on information dissemination in financial markets, trading mechanisms, portfolio management, financial contracting and, most recently, corporate governance and banking.
Martin Hellwig headshot
Martin Hellwig was appointed director at the Max Planck Institute for Research on Collective Goods, Bonn and professor of economics, University of Bonn (Courtesy Appointment) in 2004. He was the first chair and is currently vice chair of the Advisory Scientific Committee of the European Systemic Risk Board.

Monday, November 24, 2014

United States: New ISDA Protocol Will Limit Buy-Side Remedies In A Financial Institution Failure

from mondaq.com

Last Updated: November 24 2014
Article by Timothy W. DigginsLeigh R. FraserJames M. WiltonAnna LawryMolly Moore and Emily Roach
The ISDA 2014 Resolution Stay Protocol, published on November 12, 2014, by the International Swaps and Derivatives Association, Inc. (ISDA),1 represents a significant shift in the terms of the over-the-counter derivatives market. It will require adhering parties to relinquish termination rights that have long been part of bankruptcy "safe harbors" for derivatives contracts under bankruptcy and insolvency regimes in many jurisdictions. While buy-side market participants are not required to adhere to the Protocol at this time, future regulations will likely have the effect of compelling market participants to agree to its terms. This change will impact institutional investors, hedge funds, mutual funds, sovereign wealth funds, and other buy-side market participants who enter into over-the-counter derivatives transactions with financial institutions.
Among the key features of the Protocol are the following:
  • Special Resolution Regimes. In the wake of the 2008 financial crisis, regulators in several jurisdictions have adopted "special resolution regimes," which are designed to enable regulators to direct an orderly resolution of a distressed financial institution, including the institution's derivatives transactions. These regimes, including Title II of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, generally impose a one or two business day stay on the exercise of default rights (such as termination rights and rights to net collateral), to give the receiver or regulatory body time to transfer the failing or failed financial institution's rights and obligations to another entity. Following such a transfer, the non-defaulting party's right to exercise default rights as a result of its counterparty entering the proceedings is eliminated. The cross-border enforceability of these special resolution regimes is unclear under current law. The Protocol seeks to provide clarity, by introducing the provisions from certain eligible regimes by contract to ISDA Master Agreements and related credit support arrangements. In effect, Protocol adherents will agree to be bound by the special resolution regimes, even in situations where they might not otherwise apply.
  • U.S. Bankruptcy Code Proceedings. Particularly troubling is that the Protocol includes provisions requiring an adhering party to agree to limit (and in certain cases, eliminate) its rights to exercise remedies under ISDA Master Agreements and related credit support arrangements when an affiliate of its counterparty, such as a bank holding company, enters U.S. Bankruptcy Code or certain other U.S. insolvency proceedings. Coupled with the anticipated regulatory pressure to compel all market participants to adhere to the Protocol, these provisions will have the practical effect of amending and limiting long-standing "safe harbor" protections for derivatives contracts under the U.S. Bankruptcy Code and other U.S. law, without action by Congress.
  • Timing. The special resolution regime section of the Protocol becomes effective on January 1, 2015, for ISDA Master Agreements between voluntary adherents to the Protocol who are financial institutions covered by an eligible special resolution regime. The provisions of the Protocol that relate to proceedings under the U.S. Bankruptcy Code and other U.S. insolvency regimes (other than special resolution regimes) apply only after U.S. regulations enter into force limiting the ability of financial institutions to enter into derivatives transactions under ISDA Master Agreements that do not include provisions like those in the Protocol. Those regulations are expected to be adopted by the Federal Reserve and other U.S. regulators in the next couple of years. So far, eighteen major global banks have voluntarily adhered to the Protocol. Buy-side entities are not expected to adhere at this time. The Protocol by its terms anticipates that regulators in various jurisdictions will adopt regulations in the coming years that will prohibit financial institutions from entering into derivatives transactions with counterparties who have not adhered to the terms of the Protocol or otherwise agreed to similar terms.
A more detailed explanation of the changes to ISDA Master Agreements and related credit support arrangements made by the Protocol is included in Annex A to this Alert.
Background: From the 2008 Financial Crisis to the Protocol
Following the financial crisis in 2008 and widespread concerns about taxpayer support of financial institutions that are deemed to be "too big to fail," many jurisdictions adopted special resolution regimes. These special resolution regimes generally give regulators sweeping powers in the event a systemically important financial institution becomes distressed, with the goal of stabilizing or liquidating a failing or failed institution without severe disruption to the financial system or losses to taxpayers.2
One of the key issues regulators have sought to address in implementing special resolution regimes is termination rights in respect of a failing or failed financial institution's derivatives contracts. The special resolution regimes seek to address this issue by imposing a temporary pause - or "stay" - on the ability of counterparties to exercise direct default or cross-default rights. A temporary stay is designed to give regulators time, among other things, to oversee the transfer of derivatives contracts to a more financially sound entity or to take other actions to preserve the financial institution's contracts. Termination of derivatives contracts and the resulting capital calls made on Lehman Brothers were widely viewed as complicating the firm's resolution. Since that time, regulators have sought to implement measures to avoid wholesale terminations of a financial institution's derivatives contracts by its counterparties during a time of severe financial stress.
Addressing these issues in a cross-border context has proven challenging. Whether and how the different rules apply in the case of a global financial institution with counterparties in (and contracts governed by the laws of) multiple jurisdictions is complex and uncertain under current law. 3 As a result, some counterparties of a failing or failed financial institution may be able to terminate derivatives contracts with the financial institution, while others may not, depending on each party's jurisdiction (and the governing law of the contract). As regulators grappled with these issues, they have called upon ISDA, the primary trade association for the over-the-counter derivatives market, to implement a contractual solution.
The Protocol addresses the cross-border problem by contractually binding all adherents to the resolution laws governing a financial institution that enters an eligible special resolution regime, including any stays on the exercise of default remedies. Since special resolution regimes generally override the exercise of termination rights based on direct defaults or cross-defaults, the effect of the Protocol is to impose a contractual stay on termination of the financial institution's derivatives contracts by counterparties once the financial institution enters a special resolution regime, no matter where the financial institution or its counterparty is located (or the governing law of the contract). In addition, if the financial institution's rights and obligations under a derivatives contract are transferred to a successor as part of the resolution process, the right of the non-defaulting party to exercise termination rights as a result of its original counterparty's entering resolution proceedings is eliminated.
The Protocol also incorporates provisions relating to a proceeding under the U.S. Bankruptcy Code, including restrictions on creditor rights that otherwise would apply in a U.S. Bankruptcy Code proceeding. These include the removal of any ability to exercise cross-default rights because an affiliate of a financial institution counterparty that is listed as a "specified entity" in an ISDA Master Agreement enters a U.S. Bankruptcy Code proceeding. The Protocol also limits the ability of a non-defaulting party to exercise remedies in the event that a guarantor of a financial institution's obligations under an ISDA Master Agreement enters U.S. Bankruptcy Code proceedings. Unlike the rules applicable to an eligible special resolution proceeding, the Protocol does not limit a non-defaulting counterparty's right to terminate derivatives transactions in the event that its direct counterparty enters U.S. Bankruptcy Code proceedings—although, in fact, it seems likely that most major U.S. swap dealers will be subject to special resolution proceedings.4

Implications of the Protocol and Considerations for the Buy Side

As noted above, eighteen major global banks have voluntarily adhered to the Protocol, which is to become effective with respect to those banks and eligible special resolution regimes on January 1, 2015. It is expected that regulators will adopt regulations in 2015 and beyond that will prohibit financial institutions from entering into derivatives transactions with counterparties who have not agreed to terms like those in the Protocol. Regulations will have the effect of requiring more entities—including members of the buy side—to give up termination rights (i.e., adhere to the Protocol) in order to continue trading with financial institutions in these jurisdictions. Adherence to the Protocol will cause an adhering party to agree to these terms for all of its outstanding derivatives contracts under ISDA Master Agreements with other adhering parties.
While members of the buy side are not required to adhere to the Protocol at this time, they should begin thinking about the Protocol and its potential effect on their derivatives trading. Members of the buy side should understand the extent to which their financial institution counterparties are potentially within the scope of eligible special resolution regimes and the effect such proceedings would have on the terms of their ISDA Master Agreements, depending on the jurisdictions of the counterparties and any "specified entities" or guarantor entities of such counterparties, to determine how the Protocol would apply.
Notably, the Protocol is limited to ISDA Master Agreements and related credit support arrangements. Other types of trades, such as repurchase agreements, securities lending transactions, and derivatives that are not traded under an ISDA Master Agreement are not directly covered by the Protocol. It is not clear if and when these types of transactions might become subject to a similar industry-wide solution.
1. ISDA 2014 Resolution Stay Protocol, available here.
2. For more information about special resolution regimes, please see Financial Stability Board, Key Attributes of Effective Resolution Regimes for Financial Institutions (October 2011), available here.
3. A report published in the Federal Reserve Bank of New York's Economic Policy Review notes that Lehman Brothers Holdings Inc. was party to more than 900,000 derivatives contracts at the time of its bankruptcy, and that the U.S. Bankruptcy Code, the Securities Investor Protection Act, the Federal Deposit Insurance Act, U.S. state insurance laws, and more than eighty jurisdictions' insolvency laws were implicated in the Lehman bankruptcy. See Michael Fleming and Asani Sarkar, The Failure Resolution of Lehman Brothers, Federal Reserve Bank of New York, Economic Policy Review, Special Issue: Large and Complex Banks, Vol. 20, Number 2 (March 2014), available here.
4. This highlights the asymmetry of the Protocol. The Protocol's "stay" will not limit the rights of a financial institution, including one in an insolvency proceeding, from exercising any and all rights it may have against a non-financial counterparty.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Friday, November 7, 2014

Morning Agenda: Bank of America’s Legal Hit

from nytimes 

BANK OF AMERICA RAISES LEGAL COSTS Bank of America said in a news release on Thursday that it was nearing a deal with federal regulators to settle an investigation into the bank’s suspected manipulation of the currency market, saying it had increased its legal costs to deal with the inquiry, Michael Corkery and Ben Protess write in DealBook. The increased legal bill resulted in a $400 million charge that cut into the earnings that Bank of America reported for the third quarter a few weeks ago. The charge resulted in the bank’s reporting a loss of $232 million, or 4 cents a share, in the quarter.
The bank did not name the regulators, but people briefed on the investigation identified the agencies as the Office of the Comptroller of the Currency and the Federal Reserve. The legal costs came into focus between when the bank reported earnings on Oct. 15 and Thursday, when the bank filed its official quarterly report with the Securities and Exchange Commission. With the disclosure, Bank of America becomes the latest bank ensnared in the foreign exchange investigation to retroactively increase its expected legal costs ‒ and lower its earnings ‒ after reporting third-quarter results last month. Citigroup and JPMorgan Chase also announced in the last two weeks that they were increasing their estimates for legal expenses.
In addition to the comptroller’s office and the Fed, British regulators are separately closing in on deals with six banks, including Citigroup and JPMorgan, and are aiming to announce settlements by the end of the month. The Commodity Futures Trading Commission may join those civil agreements, while the Justice Department in Washington is pursuing a different route with a potential criminal case against at least one bank by the end of the year. Bank of America is a smaller player in the currency market than many of its peers and its penalties are expected to be smaller. In August, Bank of America agreed to a $16.65 billion deal with federal and state authorities to settle civil charges related to its sale of shoddy mortgage securities.
DETAILS ON LOW-DOWN-PAYMENT MORTGAGE PLAN |Seeking to bring more people into the housing market, the government said last month that it planned to expand the availability of mortgages with low down payments. On Thursday, the chief executive of Fannie Mae, the largest government mortgage entity, provided some crucial details on what the program would look like, DealBook’s Peter Eavis reports. In an interview, the executive, Timothy J. Mayopoulos, said that Fannie would accept more low down payment mortgages but would also require private mortgage insurance. In theory, that stipulation could limit the size of the program.
Even as the government is moving ahead with the changes, some housing analysts had concerns, contending that the program could lead to higher defaults. Since the financial crisis of 2008, some 80 percent of mortgages have had some form of taxpayer guarantee. Most of that backstop comes from Fannie and Freddie Mac, which typically only guarantee mortgage amounts that are equivalent to around 80 percent of the value of the underlying house. As a result, borrowers who take out loans backed by Fannie and Freddie often have to have the cash to make a down payment of some 20 percent of the value of the house. As part of a wider effort to increase the flow of housing credit, Melvin L. Watt, director of the Federal Housing Finance Agency, said last month that he wanted Fannie and Freddie to back loans with down payments as low as 3 percent of the value of the home.
The question now is whether private mortgage insurers have the desire to take on this business. A down payment of 3 percent would, in theory, leave the insurer taking a substantial amount of the risk if the borrower defaults, Mr. Eavis writes. But Mr. Mayopoulos expressed confidence the program would work. “Everything I am hearing from private mortgage insurers is that they have capital to put to work and they are expressing to us that they have an appetite to do that,” he said. Still, the push for low-down-payment loans will no doubt intensify the debate over how far to go in making mortgage credit more available. Many studies show that borrowers who make down payments of at least 20 percent usually have much lower default rates. As down payments fall, lending gets riskier.
MORE TWISTS IN BATTLE FOR ALLERGAN The latest court ruling in the war over Allergan was a mixed bag for the Botox maker, which has been trying for months to fend off a hostile takeover by Valeant Pharmaceuticals, Peter J. Henning and Steven Davidoff Solomon write in the White Collar Watch column. This week, a federal court ruling went in favor of Valeant and William A. Ackman’s hedge fund firm, Pershing Square Capital Management, deciding against Allergan’s efforts to prevent them from voting at a special shareholder meeting on Dec. 18 over whether to remove Allergan’s directors. But the decision may open up a new line of attack against Mr. Ackman from shareholders who sold their Allergan stock in the weeks leading up to the disclosure of Valeant’s bid for the company in April.
Allergan premised its claim on showing that the shares were acquired in violation of Rule 14e-3, a rule adopted by the Securities and Exchange Commission in the 1980s to stop insider trading in connection with hostile offers. The judge found that Allergan could not sue for a violation because it did not sell any of its shares during the period when Pershing Square was buying its stake. Still, the caseraises interesting issues about whether the insider trading rules were violated. “Valeant could have avoided all of this by simply not moving to a tender offer for Allegan,” Mr. Henning and Mr. Davidoff Solomon write. “If it would have just kept its bid open while seeking to remove the directors, then it would not have raised the insider trading question.”
So what’s next for Allergan? For one, the company is appealing the judge’s decision. But Allergan also seems to be trying a new tack in its attempt to fend off the hostile takeover. According to Bloomberg News, Allergan is said to be in active talks with Actavis on a potential alternative deal. The discussions may not lead to an agreement, said unidentified people with knowledge of the matter. Allergan said in a filing that it was in talks with a third party that may lead to merger negotiations, without providing further information. Actavis is unlikely to make a formal offer for Allergan unless it thinks Allergan’s shareholders will probably approve it, one of the people said.
IT’S JOBS DAY Economists expect the unemployment rate tohold steady at at 5.9 percent when the Labor Department releases its October figures at 8:30 a.m. The consensus is for employers to have added about 234,000 jobs in October.
ON THE AGENDA In addition to the jobs report, data onconsumer credit comes out at 3 p.m. The Bank of France holds an international symposium titled “Central Banking: The Way Forward” in Paris. Janet L. Yellen, chairwoman of the Federal Reserve, sits on a panel on macroeconomic policy at the conference at 10:15 a.m. Daniel K. Tarullo, a Fed governor, gives a speech on community banking at the 10th Annual Community Bankers Symposium at 2:30 p.m. in Chicago.
DEALBOOK CONFERENCE 2014 On Dec. 11, The New York Times will hold its third-annual DealBook conference. This year, the daylong event will be at the new One World Trade Center. Past speakers have included Lloyd Blankfein, Jamie Dimon, Elon Musk, Preet Bharara, Eric Schmidt, Indra Nooyi, Dick Costolo, Daniel Loeb, Valerie Jarrett and many others. Invitation requests areavailable online.
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Saturday, November 1, 2014

Has The Bank Of Japan Started Another Round Of Central Bank Wargames?

from forbes


Frances Coppola

Never pick a fight with a central bank. The only one who gets hurt is you. Unless, of course, you are another central bank.

Central banks routinely intervene in the markets to influence the prices of assets, commodities and currencies. That’s the way monetary policy is conducted. It’s the principle behind QE.

Generally, everyone co-operates. When a central bank announces that it intends to buy assets, investors queue up to sell – even though they presumably have optimized their asset portfolios. Some of those who opt to sell to a central bank would no doubt have sold anyway. Others perhaps bring forward sales that they would have made at a later date. And others may seize the moment to make opportunistic sales. But there has never yet been a central bank that couldn’t find assets to buy when it wanted them. If a central bank wants to buy assets, markets make assets available.

The reason for this is something of a mystery, but I think it is really simple game theory. The reason everyone co-operates with central bank bond buying programmes is that there is no point in not doing so. A currency-issuing central bank has infinite resources. No-one else does. The only way of winning this game is to co-operate with the player who can’t lose – i.e. the central bank. So in the end, the central bank will buy everything it wants to, simply because it can. And because market participants believe this, an asset-buying central bank effectively controls the market price not only of the assets that it buys, but also of the currency that it issues to buy them.

Japan’s central bank is buying large amounts of assets as part of the Japanese government’s combined monetary and fiscal stimulus program designed to end Japan’s long-standing economic stagnation. Here’s what happened to the yen today (chart from Bloomberg ):
jpyusd 31 oct

That sharp drop occurred when the Bank of Japan announced a massive expansion of its asset-buying program. On its website, the Bank of Japan states that the purpose of the asset-buying is to maintain inflation at the Bank’s target of 2%. But the immediate effect was to devalue the yen and raise stock and bond prices.

Inevitably, the Bank of Japan’s action was hailed as “currency war”. In the Wall Street Journal, Michael Casey writes:
A currency war looms – not a 1930s-style scorched-earth conflict, but a damaging stealth war that will exacerbate the global economy’s woes and distort domestic political agendas…..
As a weakening exchange rate drives down the price of its cars and electronic goods overseas, Japan creates competitive challenges for other countries’ producers, putting jobs at risk and policymakers in those places under political pressure to respond.
And he warns:
The biggest players in the global monetary system have mostly resisted direct tit-for-tat responses to Japan’s yen-weakening moves over the past two years. But it’s only a matter of time before their policymakers use words or actions to combat its effect. The upshot: even more global deflation and sluggish growth.
Aha. So it is not quite true that a currency-issuing central bank has no opponents. No-one in the private sector will oppose it, unless they have a deathwish. But other currency-issuing central banks might, if they perceive its actions as threatening to their own economies. Economic wars are played out between central banks. Market participants will co-operate with the central bank that adopts the game strategy that best fits their own interests. And as each central bank defends its own economy, when central banks are fighting, markets fragment along national lines. As Casey says, central bank wars can be very damaging.

So far, central banks have been fairly tolerant of the Bank of Japan’s market intervention, no doubt because large though the Japanese QE has been relative to the size of the Japanese economy, until now the Fed’s QE program has dwarfed it. But the Bank of Japan has now doubled its QE program, while the Fed has ended QE. Will central banks be quite so tolerant now – or will we see a round of defensive responses to the Bank of Japan’s move?