Goverments Commit Taxpayers To Prop Up Failing Banks

The Connection Between Overseas Bank Bailouts And The recently Publicised Events In New Zealand

A SELF EXPLANATARY TALE

Researched And Compiled By Iain Parker June 2008

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CHAPTERS-
1 – British government commits taxpayers to bailing out the banks 26 April 2008

2 – Reform Of The Reserve Bank Of New Zealand’s Liquidity Management Operations June 2006

3 – New Zealand Govt Increases T-bill Tender 10-9-07
4 – RBNZ Readies To Shore Up Banks 08 May 2008

5 – GOVERNMENT SECURITIES TENDERING

IMPORTANT CHANGES IN TENDERING OPERATIONS
18 February 2008
6 – Westpac To Offer World Bank Notes 18 June 2008
7 – NZ Current Account Deficit Soars 26 June 2008
8 – Australian Banks Prepare For Worst June 27, 2008
9 – DOLLAR DECEPTION: July 3, 2007
HOW BANKS SECRETLY CREATE MONEY

10 – Excerpts from Reserve Bank of New Zealand: Bulletin, Vol. 71, No. 1, Themed issue: Money and credit March 2008

11 – Excerpts from the New Zealand Bankers Association 2006 – Banking In New Zealand Fourth Edition PAGE 18 – 22 THE CREATION OF MONEY AND CREDIT

12 - Central Banks To Prop Up Non Bank Deposit Takers SEPT 2007

1 – British government commits taxpayers to bailing out the banks

By Jean Shaoul
26 April 2008

The government and the Bank of England have been forced to step in to bail out Britain’s banking system, which is on the point of collapse.

The measures go beyond those taken by the US Federal Reserve or the European Central Bank in offering almost limitless liquid assets, in effect backed by future taxpayers’ funds. They reflect the increasing financial turmoil and threaten to bankrupt the British government itself.

The Governor of the Bank of England, Mervyn King, announced a series of measures of a quite unprecedented scale and scope under a “special liquidity scheme”. The Bank would accept the banks’ AAA rated mortgage and credit card backed securities-which have in fact becoming untradeable and thus worthless—but not those related to the US sub-prime market. These AAAs would be swapped for short dated and highly liquid Treasury bonds for one to three years, at a discounted rate or “haircut”, to use the City’s jargon.

This facility would be available for up to six months, after which it would be reviewed, but would be limited to securities created up to the end of last year in order to discourage the banks from issuing new mortgage-backed securities. The banks will be able to sell the Treasury bonds for cash, thereby reducing their borrowing costs. The nature of the swap facility means that it is only available to large scale lenders who securitised their loans, not the small building societies.

The banks will have to pay a fee based on the inter bank lending rate, Libor, the rate banks lend to each other for 90 days and which is one percentage point above base rates. This rate will make it expensive to use.

The terms will be similar to those offered on the Bank’s recent three month liquidity injection for AAA rated mortgage backed securities. These ranged from 4 percent for short term mortgage backed securities with less than three years to maturity to 22 percent for those with 10-30 year to maturity, with a further charge for non-sterling denominated securities. But since these AAA securities are now unsaleable, the banks will get short dated gilts that can be traded for cash. Britain’s central bank on the other hand will be stuck with long dated and potentially worthless securities whose annual interest commitments it will have to honour at higher rates than public debt.

Furthermore, since the Bank does not have any Treasury gilts it does not issue them. That is the role of the Debt Management Office (DMO), a Treasury agency. This is therefore a government initiative, paid for by the broad mass of the British people, to prop up the banks.

While the Bank talked in terms of £50 billion, most commentators think that the initial call is more likely to be at least £100 billion. The governor admitted as much when he said, “Usage of the scheme will depend upon market conditions. Discussions with banks suggest that initial use of the scheme is likely to be around £30 billion” [emphasis added]. There would be “no arbitrary upper limit”. In essence, the Bank will do whatever it takes to rescue the banks.

Since either sum is far more than the £63 billion that the DMO expected to issue for 2008-09 to meet the government’s borrowing needs, the DMO will have to issue additional Treasury stock for the purpose. Moreover, the Bank has said that it will not disclose the use made of the swap facility as long as it lasts—despite this in effect being public money-in order to not to stigmatise those banks seeking financial support.

The announcement follows months of pleading, Prime Minister Gordon Brown’s meeting with bankers on Wall Street and a series of meetings with bank CEOs at Downing Street last week. There the bankers held a gun to the government’s head and, to use the Financial Times’ Lex columnist’s words, “warned the government of Armageddon” if the Bank of England did not reverse its publicly-stated refusal to rescue the banks from their own recklessness.

Chancellor Alastair Darling claimed that the government had taken these steps to increase liquidity and unfreeze the mortgage market—and make funds available to prospective home buyers who have been finding it hard to get a mortgage—thus preventing prevent the housing market from collapsing, and home owners findings themselves with negative equity. He also suggested that banks would be asked to pass on the effects of lower interest rates and greater liquidity to borrowers.

This is untenable. New mortgages were more than £370 billion in 2007 and the Bank was talking in terms of a £50 billion swap. The Bank and financial commentators immediately contradicted what was clearly the government’s spin on the bailout. King was quite explicit. The scheme was not designed to encourage new mortgage lending, which is why mortgages signed in 2008 will not be accepted as collateral, but to provide the banks with greater funds, which they could lend, if they chose to do so. He has as yet issued no details about how much, if any, of the new cash can be recycled into new mortgages.

Despite his denials, King all but admitted that the banks were at the point of collapse—evoking images of a public run on the banks. King said, in response to criticisms for not acting earlier, that it had only been in recent weeks that the fragility of the banking system had been exposed, threatening painful effects on the wider economy if credit for households and small businesses dried up.

He said, “This is not to protect the banks but to protect the public from the banks. There is no way that the banks can access this [the swap facility] as a bottomless pit. It is not available for failing institutions. It is to restore confidence in the banking system as a whole.”

The Band of England gave no indication of the conditions, if any, it had placed on the banks and building societies, in effect giving an open ended commitment to ensure the banks’ financial viability.

The official line of the bankers, issued in a statement by the British Bankers’ Association, was that they were “participating in this arrangement and expect it to make a significant contribution to alleviating the pressures in the UK money markets. Restoring confidence in the whole sale funding market will strengthen the financial system and the stability of our economy.”

But privately, the bankers were more explicit. Strengthening “our economy” was code for re-building their capital reserves—which their own reckless practices had eliminated—and boosting their profits. They let it be known that the swap facility would merely allow them to maintain their present low level of lending rather than returning to the lending levels of 2007.

They also warned that the special liquidity scheme would not reduce the cost of mortgages, which would remain high relative to the Bank Rate, nor would it increase the amount of mortgage lending, which fell in March to 50 percent of that of March 2007. As far as they were concerned, if the government wanted to boost the mortgage and housing market, the Bank would have to cut interest rates.

But the currency markets would have none of that. The pound immediately fell by 1.5 percentage points, reducing sterling to 80 percent of what it was relative to the Euro a year ago. Should it fall further and more precipitously, the government and the Bank of England may be faced with no option but to increase the Bank Rate.

That the government had had to come to the banks’ rescue was a tacit acknowledgement that the raft of measures taken over the last eight months at enormous cost to the taxpayer to prevent just such a collapse had failed and failed disastrously. These include shoring up and later nationalising Northern Rock, the UK’s fifth largest mortgage lender, cutting interest rates, and injecting billions of pounds into the frozen credit markets,. The shareholders of the now nationalised Northern Rock in fact protested that they had been explicitly denied the very facilities that the Bank was now granting the banks.

The inability of these measures to resolve the crisis stems from the fact that the central problem is not one of liquidity, but solvency. The latest scheme—a mere drop in the ocean—will be no more successful. Indeed, the US Federal Reserve noted that in principle the mortgage credit risk lies with the banks, so that while the Bank’s swap facility may help liquidity it will do little to help concerns about solvency.

Not only are Financial Services Authority and the Bank urging the banks to rebuild their capital reserves, something they have thus far resisted, but the banks face a wave of new write downs on their more exotic financial instruments which will affect their capital ratios.

Almost all Britain’s high street banks, Barclays, Lloyds TSB, Royal Bank of Scotland, Halifax Bank of Scotland and Abbey, said they would use the swap facility, indicating just how systemic the financial crisis is. Estimates in the financial press suggest that will use at least £37 billion of the swap facility simply to rebuild their capital reserves.

The attempts of the authorities to shore up the banks come at the expense of the workforce, borrowers and the tax payers. The credit crunch will wipe out tens of thousands of jobs in the financial sector upon which one in ten Londoners depend and hundreds of thousands more as businesses are unable to access working capital to keep going.

Not a penny has gone to borrowers who are struggling with exorbitant interest and mortgage repayments based upon inflated house prices. The swap facility will, as the Council of Mortgage Lenders points out, do nothing to make more money available to existing or new borrowers. This will lead to falling house prices, leaving households facing negative equity on their over priced homes. As unemployment rises, they will be faced with the repossession of their homes.

Just as exposed is the government itself and thus the taxpayers. Public debt was about £576 billion at the end of the 2007 fiscal year and is set to rise much further. But this is only part of the total public debt, some of which—like the banks’ infamous securitised assets—has been manipulated so as to be off balance sheet. There are also “contingent liabilities”: guarantees, both explicit and implicit, to the private providers of public services, few of which are disclosed or subject to public scrutiny due to commercial sensitivity.

Off balance sheet debt and contingent liabilities include the debt resulting from the Private Finance Initiative, the debt guarantees for Network Rail, the cost of nuclear decommissioning and clean up, and nationalising Northern Rock, plus the myriad of soft guarantees and “support” underpinning the government’s Public Private Partnerships. These, together with the Bank of England’s swap facility, which looks set to rise, would double this figure, bringing it close to total GDP.

If or when these contingent liabilities materialise, they will crowd out expenditure on public services, leading to tax rise and service cuts on a scale never before seen.

These latest measures comes just a few weeks after the collapse of Bear Stearns, one of the US’ largest financial institutions, which was rescued by bailout organised by the Federal Reserve, and rumours that Britain’s Halifax Bank of Scotland (HBOS) was on the brink of collapse, precipitating a wave of share selling.

The swap facility was announced on the same day that Europe’s second largest high street bank, the Royal Bank of Scotland (RBS), unveiled its plans to launch a £12 billion rights issue, the largest in European corporate history, larger even than the rights issue by the beleaguered Swiss bank, UBS. It is thought that some of the other banks and mortgage lenders may follow suit.

RBS also announced that it would sell off its highly profitable insurance arm. It is already in talks to sell off its train leasing operations, whose huge profits are dependent upon government subsidies, and which is expected to realise £3.5 billion, nearly ten times the price it paid for the company in 1997.

RBS has pledged a cost cutting campaign that will see a cull of thousands of jobs. It must also offer a massive fee to get the issue underwritten and price the new shares at a huge discount, increasing the number of shareholders and demands for future dividends by more than 60 percent. Bank shares, which had earlier risen in the wake of the |Bank of England’s rescue, fell across the board as the implications of this sank in.

2 – Reform Of The Reserve Bank of New Zealand’s

Liquidity Management Operations June 2006

I Introduction

1. In the 2004–2005 Annual Report, the Reserve Bank announced that one of the Governor’s priorities for the 2005–2006 financial year was for the Bank to work to ensure that adequate liquidity was being provided to the banking system, with collateral requirements and risks being balanced appropriately between the Reserve Bank and the New Zealand banking sector.1

2. In March 2006, the Bank released a consultation document2 that described the Reserve Bank’s review of liquidity management. It set out the rationale for the review, the desirable features of a liquidity regime and the key design issues. A range of possible options was discussed and the Bank’s preferred regime was

described. The paper sought public comment on a proposed new regime for the Reserve Bank’s domestic money market operations. Those interested in the background, and the motivations behind the proposed changes are encouraged to read the consultation paper.

3. The period for submissions on the consultation paper closed on the 20th of April 2006. Submissions were received from a number of banks and indicated support for the proposed reforms.

4. Submissions were supportive of the broad thrust of the new regime. Some particular concerns of individual banks were raised but these did not present compelling reasons for the Reserve Bank to change substantively the preferred regime.

5. This document provides details of the regime that has been adopted by the Reserve Bank and guidelines to the Bank’s operations during its implementation. The reforms will be implemented gradually over the coming months. Adopting a phased approach will enable system participants and the Reserve Bank to

gradually adjust to the new environment. In particular it will enable the Reserve Bank to gauge the demand for cash and determine an appropriate longer-term level for settlement cash.

6. The last section of this document specifically addresses a number of questions that should clarify some of the main issues associated with this reform and answers some common questions which arose in the submissions. There is also an appendix which provides details of the implementation process and operational guidelines.

II The new liquidity management regime

7. The building blocks of the new liquidity management regime are as follows:

• The Reserve Bank will discontinue its intraday automatic reverse repurchase facility (Autorepo). The Bank will also discontinue the acceptance of bank bills and other non-government securities as security as part of the Bank’s normal money market operations.

• As a consequence, the Reserve Bank will supply a significantly higher level of cash than before – a level consistent with the trend demand for cash from the overall system. This higher level of cash is expected to enable participants to efficiently settle day-to-day gross payments obligations. In addition, the total level of cash may well also satisfy some or all of banks’ demands to hold liquid assets to meet, for example, extreme events and/or (external) regulatory requirements. The Bank does not know in advance with certainty what the final target level will be, but our analysis suggests a likely range of $5,000 –7,000m. The actual final level of cash will reflect the level of demand from market participants as revealed in the interest rates they are prepared to pay to raise cash in the short term money markets.

• Consistent with much higher cash balances than at present, the day-to-day variability in system wide settlement cash balances will be much greater. The Bank will aim to maintain the forecast daily cash balance within ±$500m of the target level (currently the Bank arranges its operations with the aim of maintaining a fixed cash target with the expectation of forecast errors of ±$20m around that fixed target most of the time).

• Changes to the settlement cash level (SCL) are expected to be made infrequently and will reflect changes in the overall system’s trend demand for cash. The Reserve Bank will continually monitor the various measures available to it to ensure that the Bank is aware of the system-wide demands for liquidity.

Note that notwithstanding the above, the Bank will continue to reserve the right to make short notice changes to the cash target in the event of exceptional circumstances. Any changes to the target level will be announced through various electronic media.

• The Bank will now remunerate cash balances at the Official Cash Rate (OCR) compared with OCR -25 basis points (bp) at present.

• The Bank will continue to offer to approved counterparties a secured cash raising facility (the Overnight Reverse Repurchase Facility – ORRF). The cash raised will be secured over government debt, at a margin of 50bp higher than the rate paid on overnight cash balances. This facility will provide market participants with a secured source of funds, at a penal rate, in the event that cash is not otherwise available in the market.

3 – New Zealand Govt Increases T-bill Tender 10-9-07

Interest.co.nz 10-9-07

The Government is responding to the global credit crunch by increasing the amount of Treasury Bills for sale tomorrow.

After the tender it will consider if it needs to increase the amount of government bonds sold in its next monthly tender.

The New Zealand Debt Management Office (DMO) said today it would sell $250 million of three-month bills at an auction on Tuesday.

This is an increase of $50m on recent sales and $150m more than the amount offered before credit quality became a concern of investors in the wake of the US subprime lending meltdown.

“This increase is in response to the current strong demand for government securities,” DMO Treasurer Philip Combes said.

“Relative to a month or two ago there has been a marked increase in demand, and we have increased the volume by more than double,” he said.

Investors’ appetite for debt instruments issued by governments has increased globally.

As a consequence the “spread”, or difference in yields, between three-month Treasury Bills issued by the New Zealand Government and Bank Bills issued by banks has widened to 150 basis points from the more usual 50 points or less.

Treasury Bill yields have fallen while Bank Bills yields have risen.

The Government is, in effect, getting cheap money because of its credit quality and could end up in a position of raising more money than it needs if the situation carries on for too long.

Both government bills and bonds are in short supply in the market because demand has increased.

“This global credit crunch is causing people to increase their demand for the highest credit qualities,” Mr Combes said.

The government has been investing the money raised from the extra Treasury Bill sales in the short term pending its use at a later stage.

The Government is currently planning to sell $2.5 billion of government bonds by tender in the year to June 30, 2008. The monthly tenders are generally $200m in size but last month’s tender was increased by $100m.

The size of the next tender will be considered after the Treasury Bill tender on Tuesday.

“We will review what we are going to do for our next monthly (bond) tender at the conclusion of the Treasury Bill tender tomorrow,” he said.

Increasing the size of the bond tender is an option.

“By issuing now when there is strong demand for our securities, that could just mean we are effectively bringing forward the timing. It doesn’t necessarily have implications for how much we are going to do for the full year,” he said.

4 – RBNZ Readies To Shore Up Banks 08 May 2008

By MARTA STEEMAN and ALAN WOOD – The Press | Thursday, 08 May 2008

The Reserve Bank of New Zealand (RBNZ) is preparing to be the lender of last resort to protect the banking system.

The central bank yesterday announced easier lending to the banks to shore up national defences against any future international market shocks.

For the first time, the RBNZ said it was prepared to take home loans as collateral for lending to the trading banks.

In a worst case scenario, New Zealand taxpayers, through the Reserve Bank, could be left holding the home loans of a bank that fails and owning a bank, Reserve Bank spokesman Mike Hannah confirmed.

RBNZ Deputy Governor Grant Spencer said the measures being taken mirrored similar actions by other central banks in the wake of global financial market turmoil.

Governor Alan Bollard said the new measures would ensure the workings of the banking system in turbulent times.

That included extending the range of securities it would accept from banks as collateral for overnight lending that banks do to settle daily transactions.

From June 3, the RBNZ would accept residential mortgage-backed securities as collateral, along with government and local body stock and debt securities from state-owned enterprises.

The banks will have to package up their residential mortgages into securities to make use of these new measures.

Bollard said New Zealand’s financial system had little exposure to overseas credit risk or the structured debt products that had damaged the balance sheets of some overseas banks.

“Bank balance sheets remain solid, with appropriate capital buffers.”

New Zealand banks had been impacted by the global tightening in liquidity and availability of funds and were facing a higher cost of funds and reduced liquidity in some markets.

This had flowed through to higher borrowing costs for businesses and households.

“The IMF (International Monetary Fund) has described recent events as the largest financial shock since the Great Depression,” Bollard said.

“Adjustment could be protracted, and further volatility in world equity markets, exchange rates and debt markets looks likely.”

A banking specialist David Tripe said he did not see much risk in the central bank accepting mortgage-backed securities.

Tripe said there were minimal amounts of these securities in New Zealand unlike the United States where these securities triggered the sub-prime mortgage meltdown.

But market commentator and business consultant Charles Levin said the Reserve Bank’s exposing itself to residential mortgages took it into dangerous territory and was “revolutionary”.

Normally it only took government or local-government backed bonds as the safeguards for loans.

“What it’s done has gone from taking gold-plated assets as security … to lending money against mortgages. That has enormous implications,” Levin said.

If the housing market slumped badly or something else happened to make mortgage-backed securities less saleable, the RBNZ would be caught in a situation where it had to provide even more liquidity.

“As the bank accumulates more and more of these mortgages as security it becomes more and more exposed to the New Zealand mortgage market, and therefore so does the New Zealand taxpayer.”

Hannah said the mortgage-backed securities would have to be at the top end, unlike those in the United States.

Banks might never use the measures but if they set up the mortgage-backed securities they had a way of “unlocking the worst case scenario”.

While that was exposing the central bank to the housing market, Hannah said the housing market was considered lower risk and consisted of tangible assets for which there would always be a market, unlike bank “paper” securities.

The banks were not asking for this, Hannah said. The central bank had been studying what was being done overseas.

 

5 – GOVERNMENT SECURITIES TENDERING

IMPORTANT CHANGES IN TENDERING OPERATIONS 18 February 2008

The New Zealand Debt Management Office (NZDMO) will be assuming responsibility for the tendering of New Zealand Government Bonds and Treasury Bills from the Reserve Bank of New Zealand (RBNZ). The transfer will be a staged process that will take place over the next two months. This follows many years of the RBNZ acting as an agent for the NZDMO.

From the market’s perspective, little will change on handover from the RBNZ:

· Austraclear will continue to be used to place bids and settle successful bids.

· NZDMO will continue to make all decisions on offerings for each tender and on the

allotment of bids.

Some changes have been made to simplify the Operating Rules and Guidelines and

registration criteria:

· Bid limits and bid deposits have been eliminated.

· The process for placing telephone bids has been simplified.

· The registration process has been simplified.

To qualify for registration as a bidding counterparty, applicant institutions must

have a minimum credit rating of A-/A3 or be a Crown Financial Institution. Please

see Application for Registration as a Bidding Counterparty for further details.

The handover will be done in two stages:

· In the first stage, effective from Monday 3 March 2008, NZDMO will take over the

settlement of successful bids for tenders conducted after this date; and

· In the second stage, effective from Monday 7 April 2008, NZDMO will take over the

remaining tender functions (i.e. making tender announcements to the market1,

administering tenders on Austraclear, and processing bids).

IMPORTANT: The following key dates and actions are important to ensure your continued

participation in Government securities tenders:

· By 29 February we require settlement instructions for government securities from

existing registered bidders. Please provide on letterhead and fax to us on +64 4 472

3792.

· From 3 March, all settlement of the issue of Government securities will be

processed through the NZDMO Austraclear mnemonic CSAW40. This mnemonic

replaces the current RBNZ mnemonic RBNZ40.

1 Refer Reuters page NZDMOINDEX and Bloomberg NZDM

If you have any questions regarding this process, please contact Bronwyn Bayne on 917-

6131 in the first instance.

Phil Combes

Treasurer

New Zealand Debt Management Office

6 – Westpac To Offer World Bank Notes 18 June 2008

Wednesday, 18 June 2008
Westpac Institutional Bank has been appointed lead manager to distribute a new retail investment product from the World Bank in New Zealand.

The senior unsecured notes require a minimum holding of $5000. The issuer is the International Bank for Reconstruction and Development (IBRD), which has a AAA/Aaa rating.

Rod Smith, Westpac’s head of debt capital markets , believes the investment will appeal to socially responsible institutional and retail investors.

The interest rate will be set on July 14 and will be the base rate of the four-year swap rate, less the margin.

If set today, the interest rate would be 7.22-7.24 percent with a margin of -34 to -36 basis points.

The offer will open next Monday for three weeks.

NZPA

7 – NZ Current Account Deficit Soars 26 June 2008

Thursday, 26 June 2008

New Zealand posted a much worse than expected $2.16 billion current account deficit in the March quarter, figures released today by Statistics New Zealand (SNZ) show.

The surprising bad news came despite the first actual dollar goods surplus for a March quarter, at $295 million, since 2003.

The median forecast of economists in a Reuters poll had been for a quarterly deficit of $1.66b.

The March year deficit was $13.79b against the median forecast of $13.25b, and $13.84b in the December year. The annual deficit equated to 7.8 per cent of Gross Domestic Product.

The New Zealand dollar fell on the news – initially to US75.71c from US75.83c before the announcement.

From the year ended March 2007, the goods deficit had decreased $1.08b, while the income deficit had increased $1.26b.

The current account, also known as the balance of payments, measures all this country’s transactions with the outside world including interest payments and investments.

SNZ said the seasonally adjusted current account deficit increased by $410m in the March quarter to $3.53b, mainly due to larger deficits on investment and trade in goods.

The investment income deficit, which is not seasonally adjusted, grew by $315m in the quarter. That was caused by a $346m fall in income earned from New Zealand investment abroad, slightly offset by a $31m fall in income earned by foreign investors in this country.

The lower income from New Zealand investment abroad was mostly due to a fall in income earned by overseas subsidiaries of New Zealand companies.

The seasonally adjusted balance on goods was a deficit of $158m, with exports of goods up $245m and imports up $384m from the December quarter. Both exports and imports of goods are at their highest levels ever recorded.

In the March quarter, the current account deficit was financed by a net capital inflow of $2b, made up of $7.8b of foreign investment in this country, partly offset by $5.8b of New Zealand investment abroad.

The key feature of the foreign investment in this country was an inflow of debt in the form of securities and loans, SNZ said.

That inflow was partly offset by New Zealand investment abroad in reserve assets, portfolio investment in shares and securities, and direct investment in overseas companies.

The net international investment position showed a net debtor position – liabilities exceeding assets – of $153.2b at March 31. That was $1.9b larger than the net debtor position at the end of December, and $10.2b larger than a year earlier.

- NZPA

8 – Australian Banks Prepare For Worst June 27, 2008

Scott Murdoch June 27, 2008

Australia’s banks have been bundling mortgages into securitised packages to access emergency funding from the Reserve Bank, if they were ever to strike cash troubles.
The RBA’s assistant governor of financial markets, Guy Debelle, has revealed eight Australian banks had taken the advice of the central bank and APRA, the prudential agency, to package and securitise residential mortgages which had been held on their balance sheets.
The move would allow the banks to effectively swap the residential mortgage-backed securities (RMBS) with the Reserve to secure funding quickly if it was facing a liquidity shortfall.
Dr Debelle told the Australian Debt Markets Conference in Sydney that during the peak of the credit market turmoil in the past year, the overnight cash rate would have risen above the official rate if the RBA had not acted in the domestic money markets.
He said that, on an exchange settlement basis, demand from borrowers and lenders had forced the RBA to increase its usual activity from $750 million to more than $5 billion on some days.
The increased demand for funds came after banks became hesitant to lend to each other, preferring instead to hoard cash.
“If the Reserve Bank had not increased the supply, the cash rate would have risen above the target set by the Reserve Bank Board as financial institutions bid harder for funds in an attempt to increase their cash balances,” Dr Debelle said.
“Because of the framework for monetary operations, in particular the fact that we deal in the market every day, the Bank was able to very quickly gauge the extent of the increased demand for cash and react accordingly.”
Dr Debelle told the conference that the RBA had dealt with APRA to encourage the banks to take action to avoid potentially disastrous consequences if they were to ever effectively run out of cash.
“The Reserve Bank has been working with APRA and market participants to strengthen arrangements for dealing with extreme market disruptions.
In such circumstances, the Bank would be willing if an institution is experiencing serious funding difficulties to provide funds against RMBS collateral to which it is “related”.
“Reflecting that, both the Bank and APRA have encouraged depository institutions to package residential mortgages they are retaining on their balance sheets into a securitised form as a means of accessing contingent financing from the Bank.
To date, eight institutions have created these “self-securitised” RMBS and several more are in the process of doing so.”
Activity in the RMBS market has been relatively frozen during the credit crunch, but Citi recently carried out a $500 million deal with mortgages bundled together from Citibank.
The RBA, in October, became one of the first central banks in the world to accept RMBS as part of its repo agreements.
However, Dr Debelle said the bundled mortgages made up only $3 billion of the bank’s $60 billion repo portfolio.

9 – DOLLAR DECEPTION: July 3, 2007

HOW BANKS SECRETLY CREATE MONEY

Ellen Brown, July 3^rd, 2007

It has been called “the most astounding piece of sleight of hand ever invented.” The creation of money has been privatized, usurped from Congress by a private banking cartel. Most people think money is issued by fiat by the government, but that is not the case. Except for coins, which compose only about one one-thousandth of the total U.S. money supply, all of our money is now created by banks. Federal Reserve Notes (dollar bills) are issued by the Federal Reserve, a private banking corporation, and lent to the government.¹ Moreover, Federal Reserve Notes and coins together compose less than 3 percent of the money supply. The other 97 percent is created by commercial banks as loans.²

Don’t believe banks create the money they lend? Neither did the jury in a landmark Minnesota case, until they heard the evidence. First National Bank of Montgomery vs. Daly (1969) was a courtroom drama worthy of a movie script.³ Defendant Jerome Daly opposed the bank’s foreclosure on his $14,000 home mortgage loan on the ground that there was no consideration for the loan. “Consideration” (“the thing exchanged”) is an essential element of a contract. Daly, an attorney representing himself, argued that the bank had put up no real money for his loan. The courtroom proceedings were recorded by Associate Justice Bill Drexler, whose chief role, he said, was to keep order in a highly charged courtroom where the attorneys were threatening a fist fight. Drexler hadn’t given much credence to the theory of the defense, until Mr. Morgan, the bank’s president, took the stand. To everyone’s surprise, Morgan admitted that the bank routinely created money “out of thin air” for its loans, and that this was standard banking practice. “It sounds like fraud to me,” intoned Presiding Justice Martin Mahoney amid nods from the jurors. In his court memorandum, Justice Mahoney stated:

Plaintiff admitted that it, in combination with the Federal Reserve Bank of Minneapolis, . . . did create the entire $14,000.00 in money and credit upon its own books by bookkeeping entry. That this was the consideration used to support the Note dated May 8, 1964 and the Mortgage of the same date. The money and credit first came into existence when they created it. Mr. Morgan admitted that no United States Law or Statute existed which gave him the right to do this. A lawful consideration must exist and be tendered to support the Note.

The court rejected the bank’s claim for foreclosure, and the defendant kept his house. To Daly, the implications were enormous. If bankers were indeed extending credit without consideration – without backing their loans with money they actually had in their vaults and were entitled to lend – a decision declaring their loans void could topple the power base of the world. He wrote in a local news article:

This decision, which is legally sound, has the effect of declaring all private mortgages on real and personal property, and all U.S. and State bonds held by the Federal Reserve, National and State banks to be null and void. This amounts to an emancipation of this Nation from personal, national and state debt purportedly owed to this banking system. Every American owes it to himself . . . to study this decision very carefully . . . for upon it hangs the question of freedom or slavery.

Needless to say, however, the decision failed to change prevailing practice, although it was never overruled. It was heard in a Justice of the Peace Court, an autonomous court system dating back to those frontier days when defendants had trouble traveling to big cities to respond to summonses. In that system (which has now been phased out), judges and courts were pretty much on their own. Justice Mahoney, who was not dependent on campaign financing or hamstrung by precedent, went so far as to threaten to prosecute and expose the bank. He died less than six months after the trial, in a mysterious accident that appeared to involve poisoning.⁴ Since that time, a number of defendants have attempted to avoid loan defaults using the defence Daly raised; but they have met with only limited success. As one judge said off the record:

If I let you do that – you and everyone else – it would bring the whole system down. . . . I cannot let you go behind the bar of the bank. . . . We are not going behind that curtain!⁵

10 – Excerpts from Reserve Bank of New Zealand: Bulletin, Vol. 71,

No. 1, Themed issue: Money and credit March 2008

Pages 25 – 32 The Reserve Bank, private sector banks and the creation of money and credit

Gillian Lawrence

This article provides an overview of the functions of money, and how money and credit are created in the economy. The roles of the Reserve Bank and private sector banks are illustrated, and we explain the link between money and monetary policy.

Pages 26-7 The banking and payment system, and how money and credit are created

In a modern economy, money can be created either by the central bank (the Reserve Bank, in New Zealand’s case) or by private sector institutions – in practice, mostly registered banks ( Besides the registered banks in New Zealand, certain institutions such as building societies, credit unions and finance companies also create money in the sense discussed in this article. There is no legal restriction on the type of institution that may create money in New Zealand.) Section 25 of the Reserve Bank of New Zealand Act 1989 gives the Reserve Bank the monopoly right to issue physical money (notes and coins), which enters public circulation through the private sector institutions to which it is issued.

A private sector institution can also create money by issuing claims on itself (ie, by accepting deposits) that may be transferred between, and are generally accepted by, members of the public as a means of payment. For that matter, any institution that can maintain the public’s confidence that its liabilities will be generally accepted as means of payment, can create money. Such an institution will, in practice, also be in the business of creating credit, which implies the issue of a greater value of claims on the institution than the value of Reserve-Bank-issued money the institution itself holds. In practice, by far the largest share of money – 80 percent or more, depending on the measure (discussed below) – is created by private sector institutions.

For simplicity, in what follows, we use “bank” to refer to any institution that creates money or credit. We illustrate this process of money and credit creation below, by tracing through example transactions in a hypothetical banking system.

Page 31

5 ConclusionIn this article, we have explained the manner in which money is created by the Reserve Bank and by private sector institutions. While the Reserve Bank creates fiat money, in practice, a much larger share of money is created by registered banks and other private institutions. In the process of creating money, these private institutions also create credit, which by enabling the funding of investment, contributes to the economy’s ability to grow. Payments are settled between these money-creating institutions via the interbank payment system provided by the Reserve Bank, using deposit accounts that the institutions hold with the Reserve Bank. The Reserve Bank’s operations in the payment system are the means by which the Reserve Bank sets the price of money – the OCR – in its pursuit of price stability

11 – Excerpts from the New Zealand Bankers Association

2006 - Banking In New Zealand Fourth Edition

4. PAGE 18 – 22 THE CREATION OF MONEY AND CREDIT

The Traditional View of the Process

The traditional view of the process of creating money and credit is based around cash (i.e. notes and coins) as the most basic form of money in a modern economy. A deposit with a bank represents a claim on it for a specific amount of cash. By acting as financial intermediaries and by providing non-cash means of settling transactions, banks and other financial institutions create more deposits and more credit than there is cash. The process by which money and credit are created begins with a cash injection, represented by the cash injection arrow in Figure 4. We discuss the sources of such cash injections later in this chapter. The non-bank private sector (or the general public) will hold some of this cash in their pockets and deposit the remainder with banks, represented by the deposits arrow. Some of the cash will be deposited in current accounts and some will be put aside in term or other deposit accounts. Although the public are able to draw on their current accounts by electronic means or by cheque, not all the new deposits will be withdrawn, which means that, on average, a moderate amount of cash will remain in banks’ vaults. Banks respond to this by lending some cash to customers who are willing to pay the current market interest rate for its use.

The process of lending the cash creates credit in the economy. Nowadays banks do not lend the physical cash. They provide the borrower with a credit facility such as a loan account or an overdraft on a customer’s current account. If the customer opts for an overdraft, they will make use of the credit facility by drawing on the account and using the funds to purchase something. The person or business receiving the funds will in most cases receive a deposit in an account at a bank. This moves the funds along the deposits part of the money and credit creation circuit again. The banking sector now has assets in the form of the loan and cash in its vault, which are matched by liabilities to the original depositor and to the new depositor.

By providing alternative means of settling transactions to cash and by acting as financial intermediaries, banks have created a new entity called deposit money. A drawing on an account is an instruction to a bank to shift deposit money from the account of one of its customers to someone else’s bank account. Like cash, deposit money has no intrinsic value other than the fact that people accept it as having value. People accept it because they know other people will accept it for settling transactions. The public’s belief that banks do on average make sound lending decisions acts as the effective backing of deposit money.

Page 19

What Actually Happens

In reality, although the process outlined in the previous sections could occur, cash balances in bank vaults no longer act as a constraint on bank lending in the way that they might have up until the latter part of the 20th century. The key constraint nowadays is banks need to settle the large volume of customer and other transactions on their own account with each other on a daily basis. This occurs through the payments system, as outlined in the next chapter

(see 5. THE PAYMENTS SYSTEM).

Banks settle transactions with each other through their accounts with the Reserve Bank, with these accounts having to remain in credit. This means that, when a bank makes a new loan, the proceeds of which might be credited

to an account at some other bank, it needs to make sure that it raises enough funds, either in the inter-bank money markets or from customer deposits to ensure that its net cash outflows will remain near enough to zero, and so that its position in its account at the Reserve Bank will remain in credit. In such an environment, there is still scope for a bank to expand its lending and create credit, but it is dependent on there being net inflows of funds into the banking system as a whole.

These inflows of funds may come from depositors from outside New Zealand (and we have seen significant inflows of funds from such sources in recent years), or from the government making net deposits of funds into the banking system (through its fiscal policy, as outlined below).

We also have a situation where, since 1985, New Zealand banks have not had any specific reserve requirements applied to their deposit liabilities. This means that, in theory, banks could keep on creating credit and expanding their loan portfolios indefinitely. In such an environment, it is the cost of credit, based upon the costs that banks have to pay to raise the deposits, that becomes the constraint on the quantity of credit that is created (See 6.

BANKS AND INTEREST RATES).

Page 20-1

Money and Credit Aggregates

The creation of money and credit is relevant to banks primarily because it is the process by which their assets and liabilities are created. The Reserve Bank and the government have a wider interest in the total amount of money and credit in the economy. This includes the money and credit created by non-bank financial institutions in addition to that created by banks. To measure this the Reserve Bank has constructed a data series for the money and credit aggregates.

The money supply aggregates measure how much cash and deposit money there is in the economy.

The narrowest definition of the money supply is M1. It is shown in Figure 6 to include cash and the categories of deposit money which are most readily available to settle transactions, for example, money in current accounts.

M2 is an intermediate definition of the money supply, consisting of M1plus other funds on call.

M3 is the broadest definition of the money supply used in New Zealand. It adds to M2 the categories of deposit money which are used increasingly as stores of value and less as means of settling transactions, for example, term deposits with a maturity longer than seven days.

The credit aggregates are designed to measure the amount of lending in the economy. Private Sector Credit (PSC) measures the amount of lending provided to the private sector (including firms and individuals) by New Zealand’s financial institutions, by the Reserve Bank and by the government. Domestic Credit (DC) adds to private sector credit, the amount of lending by these three groups to the government sector.

The level of domestic credit exceeds the total level of cash and deposits as measured by the M3 money supply. This is because financial institutions fund their lending both by borrowing from overseas and from other non deposit

sources (e.g., capital) in addition to using deposits. Note that the availability of credit is also impacted by the amount of deposits and other funding provided by non-residents, which totalled $75,603 million as at December 2005.

12 – Central Banks To Prop Up Non Bank Deposit

Takers SEPT 2007

Compiled by Iain Parker 1/7/08  

12 September 2007

Finance Minister Michael Cullen today announced Cabinet decissions on a new regulatory framework for non-bank deposit-takers, including finance companies, building societies and credit unions. The Reserve Bank in a news release today welcomed the Cabinet decision

Under the new arrangements the Bank’s role will be to license deposit-takers, develop and enforce minimum prudential and governance requirements and apply credit rating requirements. Trustee corporations will continue to be the front-line supervisors of deposit-takers.

For more detailed information on the key features of the new arrangements please see Questions and Answers for Deposit Takers Here, the Cabinet Paper andthe Regulatory Impact Statement (PDF 197KB) Here

Pg 4

f. Responding to RDT distress. In most cases, trustees will have responsibility for responding to an RDT’s distress, including by appointing a receiver. Some strengthening of the powers to deal with RDT distress and failure may be necessary; these will be incorporated, as appropriate, into the enhancements to the trustee regime. These are being advanced in a separate work stream in the RFPP process. The Companies Office will also continue to have the capacity to intervene in distress or fraud situations under the Corporations (Investigation and Management) Act. In situations where an RDT poses a risk to the soundness of the financial system, I am proposing that the Reserve Bank will be empowered to give directions (with the consent of the Minister of Finance) to an RDT or to recommend to the Minister of Finance that the RDT be placed into statutory management under the Reserve Bank of New Zealand Act.

Pg 18-9

RDT distress and failure

79. In June, the Committee agreed to a proposal that the Reserve Bank should have the statutory powers to respond to RDT financial distress and failure in situations where the Bank is satisfied that its intervention is required in order to maintain the soundness and efficiency of the financial system or to avoid significant damage to the financial system resulting the distress or failure of the RDT.

80. I am proposing that the RDT legislation will include powers for the Reserve Bank to intervene in an RDT distress or failure situation where the Bank considers this necessary for maintaining the soundness and efficiency of the financial system or for avoiding significant damage to the financial system resulting from the failure of an RDT by extending the application of crisis management powers under the Reserve Bank of New Zealand Act to RDTs. In these circumstances, it is proposed that:

a. The Bank would be empowered to recommend to the Minister of Finance that, by notice issued by the Minister, an RDT (and any of its subsidiaries or associated persons) be made subject to the Reserve Bank of New Zealand Act for the purposes of exercising powers under that Act to give directions to the RDT (under section 113 of that Act) or to recommend that the RDT be placed into statutory management (under section 117 of that Act), on the basis that the Act would apply to the RDT as if it were a registered bank.

b. Once a notice has been issued declaring that the RDT (and any of its subsidiaries or associated persons) is subject to the Reserve Bank of New Zealand Act for crisis management purposes, the Bank would then be able to exercise crisis management powers in that Act as if the RDT were a registered bank. With the consent of the Minister of Finance, the Bank would be empowered to suspend all or some the powers of the trustee of the RDT in question, on the basis that the trustee is exempted from liability as a result of being unable to exercise powers.

677862 – 19

c. The Bank would be required by the RDT legislation to consult with the trustees, Securities Commission and Companies Office before making a recommendation to the Minister of Finance that the RDT be declared by the Minister to be brought under the Reserve Bank of New Zealand, and before exercising any powers under the Reserve Bank of New Zealand Act in relation to the RDT.