- On money creation.
- Some misconceptions.
- Why money is less special than commonly thought.
On his blog, John Cochrane argues that banks could, and should be 100% equity financed. His points are:
(1) There are plenty of safe assets—government debt—out there and banks do not need to “create” additional safe assets—deposits.
I share this view partly. First, I don’t know what amount of safe assets are sufficient from a social point of view. Second, I don’t consider government debt to be a safe asset. Third, debt has safety and liquidity properties. The question is not only whether assets/liabilities provide sufficient safety but also whether they serve as means of payment in the same way that base money and deposits do. The key question then is: Do we need inside money? I don’t think that macroeconomics has a convincing answer to this question at this point. But I note that some preeminent macroeconomists (NK) argue that banks can create means of payment better than some governments. If this is true then John’s first argument partly misses the point (although he addresses a related point later).
In spite of these reservations, I share John’s view that in the aggregate, safety cannot be created by means of financial intermediation. Projects and claims to future tax revenue generate returns. The financial system can slice and distribute these returns in different ways (creating safer claims by rendering other claims less safe) but it cannot create safety in the aggregate.
(2) Households and firms no longer need assets (i.e., liabilities of financial institutions) with a fixed nominal value in order to make payments.
I agree. As John writes:
In the past, the only way that a security could be “liquid” is if it promised a fixed payment. You couldn’t walk in to a drugstore in 1935, or 1965, and trade an S&P500 index share for a candy bar. Now you can. (And as soon as it is cleared by blockchain, it will be even faster and cheaper than credit cards.) There is no reason your debit card cannot be linked to an asset whose value floats over time.
(3) If society really needs more “safe” claims such claims can be created on banks rather than in banks. As John writes:
Let the banks issue 100% equity. Then, let most of that equity be held by a mutual fund, ETF, or bank holding company, and let those issue deposits, long term debt, and a small amount of additional equity. Now I have “transformed” risky assets into riskfree debt via leverage. But the leverage is outside the bank.
I agree. In an article (2013) I have described a proposal by BIS economists that relies on equity financed banks and levered bank holding companies to help solve the too-big-to-fail problem.
(4) Why should less “safe” bank liabilities lead to a credit crunch?
I share John’s puzzlement with the often heard claim that fewer bank deposits would go hand in hand with less credit. I believe that this claim mostly reflects confusion about the interplay between national saving and investment on the one hand, and bank balance sheets on the other. There is no mechanical link between the two but of course, there are many indirect links.
All in all, I am as skeptical as John about the view that bank created money obviously is important. I think that bank created money has some useful roles to play but they are more subtle. At the same time, I believe that bank created money is likely to stay with us even if it is not socially useful. Proposals to ban inside money therefore are unlikely to succeed (see my writing on Vollgeld).
In its April 2017 Quarterly Report, the Deutsche Bundesbank discusses the role of banks in the creation of money. Findings from a wavelet analysis indicate that in Germany, money and credit move in parallel in the long run.
In an appendix, the report mentions possible welfare costs of curbing maturity transformation, with reference to Diamond and Dybvig’s work. This is not convincing. Unlike in the typical (microeconomic) banking model, aggregate central bank provided money need not be scarce, so there is no a priori social need for the private sector to create money.
In a CEPR discussion paper, Òscar Jordà, Björn Richter, Moritz Schularick, and Alan M. Taylor suggest that higher bank capital ratios help stabilize the financial system ex post but not ex ante, and that illiquidity breeds fragility.
Abstract of their paper:
Higher capital ratios are unlikely to prevent a financial crisis. This is empirically true both for the entire history of advanced economies between 1870 and 2013 and for the post-WW2 period, and holds both within and between countries. We reach this startling conclusion using newly collected data on the liability side of banks’ balance sheets in 17 countries. A solvency indicator, the capital ratio has no value as a crisis predictor; but we find that liquidity indicators such as the loan-to-deposit ratio and the share of non-deposit funding do signal financial fragility, although they add little predictive power relative to that of credit growth on the asset side of the balance sheet. However, higher capital buffers have social benefits in terms of macro-stability: recoveries from financial crisis recessions are much quicker with higher bank capital.
The Economist reports that forthcoming European payments regulation has the potential to disrupt the industry.
Provided the customer has given explicit consent, banks will be forced to share customer-account information with licensed financial-services providers.
… payment services … could become more integrated into the internet-browsing experience …
With access to account data … fintech firms could offer customers budgeting advice, or guide them towards higher-interest savings accounts or cheaper mortgages. Those with limited credit histories may find it easier to borrow, too, since richer transaction data should mean more sophisticated credit checks.
In the NZZ, Michael Schaefer reports on a study about the performance of Swiss portfolio managers in 2016.
- The median portfolio returns in all investment strategies except those not investing in stocks fell short of the corresponding benchmark returns.
- Only a fifth of the portfolios generated returns in excess of their benchmark.
- These numbers do not yet account for management fees.
- No portfolio manager generated high returns across all strategies.
- But some managers consistently generate high returns in certain strategies.
In the FT, Mehreen Khan reports about the resurgence of deposit flight.
In the Journal of Economic Literature, William Roberds reviews Christine Desan’s “Making Money: Coin, Currency, and the Coming of Capitalism” and he provides his own perspective on European monetary history.
… the transition of the Bank of England’s notes from the status of experimental debt securities (in 1694) to “as good as gold” (1833) required more than a century of legal accommodation and business comfort with their use.
Desan emphasizes England’s traditions of nominalism (as opposed to metallism) and monetary restraint as well as early experiments in monetary substitution in laying the foundations for the Bank of England’s success. Lobbying played its role, too.
Roberds discusses the experience of note issuing institutions in other countries.
At the time of the Bank’s founding, there were about twenty-five publicly owned or sponsored banks operating in Europe. These institutions are largely forgotten today; most were dissolved by the early nineteenth century and only one continues in existence, Sweden’s Riksbank. …
These banks were run by and for the merchant communities in their respective cities [Amsterdam, Genoa, Hamburg, and Venice] … The existence of the early municipal banks depended on a form of nominalism more extreme than what prevailed in contemporary England. Merchants in these “banking cities” were required by law and by custom to settle all bills of exchange (the dominant form of commercial credit) with transfers of money on the ledgers of the local public bank. The practical advantage of such a restriction was that it reduced or eliminated the possibility of settlement in the debased coins … the municipal banks’ ledger money was often seen as more reliable than the typical coin in circulation …
Most of these banks failed after getting involved in speculative episodes, hyperinflation, or political turmoil. The Bank of England was lucky.
In the FT, Vanessa Houlder reports about the tax evasion business. The new regulatory environment has led to portfolio adjustments and new types of behavior, and it exposes vast differences in enforcement across countries:
- Diamonds in vaults rather than financial assets.
- Trusts in South Dakota rather than anonymous bank accounts.
- Moving to a different country rather than just shifting assets.
- FATCA versus the Common Reporting Standard.
The article also links to an article by Kara Scannell and Vanessa Houlder earlier in the year entitled “US tax havens: The new Switzerland.” That article includes the following quotes:
I think the US is already the world’s largest offshore centre. It has done a real good job disabling competition from Swiss banks.
In a world where it’s very hard to hide ownership or hide assets sometimes the easiest place [is one] no one would normally think of, which is the US.
In BPEA, Natasha Sarin and Larry Summers argue that bank stock has not:
… we find that financial market information provides little support for the view that major institutions are significantly safer than they were before the crisis and some support for the notion that risks have actually increased. …
… financial markets may have underestimated risk prior to the crisis … Yet we believe that the main reason for our findings is that regulatory measures that have increased safety have been offset by a dramatic decline in the franchise value of major financial institutions, caused at least in part by these new regulations.
This table is taken from their paper:
However, their finding need not be as bad as it sounds. After all, bank regulators intended to insulate taxpayers against bank failure and to render the financial system more shock proof, not bank equity.
The blockchain technology opens up new possibilities for financial market participants. It allows to get rid of middle men and thus, to save cost, speed up clearing and settlement (possibly lowering capital requirements), protect privacy, avoid operational risks and improve the bargaining position of customers.
Internet based technologies have rendered it cheap to collect information and to network. This lies at the foundation of business models in the “sharing economy.” It also lets fintech companies seize intermediation business from banks and degrade them to utilities, now that the financial crisis has severely damaged banks’ reputation. But both fintech and sharing-economy companies continue to manage information centrally.
The blockchain technology undermines the middle-men business model. It renders cheating in transactions much harder and thereby reduces the value of credibility lent by middle men. The fact that counter parties do not know and trust each other becomes less of an impediment to trade.
The blockchain may lend credibility to a plethora of transactions, including payments denominated in traditional fiat monies like the US dollar or virtual krypto currencies like Bitcoin. An advantage of krypto currencies over traditional currencies concerns the commitment power lent by “smart contracts.” Unlike the money supply of fiat monies that hinges on discretionary decisions by monetary policy makers, the supply of krypto currencies can in principle be insulated against human interference ex post and at the same time conditioned on arbitrary verifiable outcomes (if done properly). This opens the way for resolving commitment problems in monetary economics. (Currently, however, most krypto currencies do not exploit this opportunity; they allow ex post interference by a “monetary policy committee.”) A disadvantage of krypto currencies concerns their limited liquidity and thus, exchange rate variability relative to traditional currencies if only few transactions are conducted using the krypto currency.
Whether blockchain payments are denominated in traditional fiat monies or krypto currencies, they are always of relevance for central banks. Transactions denominated in a krypto currency affect the central bank in similar ways as US dollar transactions, say, affect the monetary authority in a dollarized economy: The central bank looses control over the money supply, and its power to intervene as lender of last resort may be diminished as well. The underlying causes for the crowding out of the legal tender also are familiar from dollarization episodes: Loss of trust in the central bank and the stability of the legal tender, or a desire of the transacting parties to hide their identity if the central bank can monitor payments in the domestic currency but not otherwise.
Blockchain facilitated transactions denominated in domestic currency have the potential to affect central bank operations much more directly. To leverage the efficiency of domestic currency denominated blockchain transactions between financial institutions it is in the interest of banks to have the central bank on board: The domestic currency denominated krypto currency should ideally be base money or a perfect substitute to it, directly exchangeable against central bank reserves. For when perfect substitutability is not guaranteed then the payment associated with the transaction eventually requires clearing through the traditional central bank managed clearing mechanism and as a consequence, the gain in speed and efficiency is relinquished. Of course, building an interface between the blockchain and the central bank’s clearing system could constitute a first step towards completely dismantling the latter and shifting all central bank managed clearing to the former.
Why would central banks want to join forces? If they don’t, they risk being cut out from transactions denominated in domestic currency and to end up monitoring only a fraction of the clearing between market participants. Central banks are under pressure to keep “their” currencies attractive. For the same reason (as well as for others), I propose “Reserves for All”—letting the general public and not only banks access central bank reserves (here, here, here, and here).
In the NZZ, Axel Lehmann offers his views on the prospects of blockchain technologies in banking. Lehmann is Group Chief Operating Officer of UBS Group AG.
- Higher efficiency; lower cost; more robustness and simpler processes; real-time clearing;
- no need for intermediaries; information exchange without risk of interference
- automated “smart contracts;” automated wealth management;
- more control over transactions; better data protection;
- improved possibilities for macro prudential monitoring.
- Speed; scalability; security;
- smart contracts require new contract law;
- interface between traditional payments system and blockchain payment system.
Lehmann favors common standards and he points out that this is what is happening (R3-consortium with UBS, Hyperledger project with Linux foundation).
Related, Martin Arnold reported in the FT in late August that UBS, Deutsche Bank, Santander, BNY Mellon as well as the broker ICAP pursue the project of a “utility settlement coin.” Here is my reading of what this is:
- The aim seems to be to have central banks on board; so USCs might be a form of reserves (base money). The difference to traditional reserves would be that USCs facilitate transactions using distributed ledgers rather than traditional clearing and settlement mechanisms. (This leads to the question of the appropriate interface between the two systems posed by Lehmann.)
But what’s in for central banks? Would this be a test before the whole clearing and settlement system is revamped, based on new blockchain technology? Don’t central banks fear that transactions on distributed ledgers might foster anonymity?
In the FT, Rachel Sanderson and Martin Arnold report that the board of Monte dei Paschi is about to approve a recapitalization led by JPMorgan in order to avoid the alternative, a bailin according to European rules.
Other news sources reported that the European Commission had made it clear that it rejected the proposal by Italy’s prime minister (supported by the ECB president) to change the rules and let the Italian government finance the recapitalization. EU finance ministers and Angela Merkel had opposed the proposal as well.
This time, rules won.
A progress update by the Bank of England describes the Bank’s intention, over time,
to extend direct access to RTGS to non-bank Payment Service Providers (firms granted the status of E-Money Institutions or Payment Institutions in the UK), collectively known as PSPs. By extending RTGS access, our objective is to increase competition and innovation in the market for payment services.
In a speech, Hyun Song Shin points out that CIP increasingly fails to hold: the Dollar interest rate implied by FX swaps vis-a-vis the Euro, Yen, Pound or Swiss Franc is “too high.” Moreover, the deviation is negatively correlated with the Dollar’s spot exchange rate: When the Dollar appreciates, the deviation from CIP widens.
Shin argues that bank behavior explains the deviation:
… the US dollar is used widely throughout the global banking system, even when neither the lender nor the borrower is a US resident. … The consequence of the dollar’s international role in transactions is that the global banking system runs on dollars.
… key feature of the risk-taking channel is that when the dollar depreciates, banks lend more in US dollars to borrowers outside the United States. Similarly, when the dollar appreciates, banks lend less, or even shrink outright the lending of dollars. In this sense, the value of the dollar is a barometer of risk-taking and global credit conditions.
… The breakdown of covered interest parity is a symptom of tighter dollar credit conditions putting a squeeze on accumulated dollar liabilities built up during the previous period of easy dollar credit. During the period of dollar weakness, global banks were able to supply hedging services to institutional investors at reasonable cost, as cross-border dollar credit was growing strongly and easily obtained. However, as the dollar strengthens, the banking sector finds it more challenging to roll over the dollar credit previously supplied.
One way to summarise the finding is that there is a “triangle” that links a stronger dollar, more subdued dollar cross-border flows, and a widening of the cross-currency basis against the dollar.
With the Euro’s rising role as an international funding currency CIP deviations also show up for the Euro.
… the risk-taking channel for the euro is starting to show the tell-tale negative relationship between a weaker currency value and expanding cross-border lending in that currency; it was not there before the crisis, but has emerged since the crisis.
The financial channel of exchange rates operates when currency appreciation elicits valuation changes on borrower balance sheets. …
When we do international finance, we often buy into the “triple coincidence” where the GDP area, decision-making unit and currency area are one and the same … Currency appreciation or depreciation then acts on the economy through changes in net exports. [But that’s misleading.]
In the FT, Martin Arnold reports about estimates by Fitch according to which
European banks would have to raise up to €170bn of extra capital or sell almost €500bn of sovereign debt if regulators push ahead with plans to break the “doom loop” tying lenders to their governments …
The European Commission and the European Central Bank support steps in that direction while some European governments oppose them.
On VoxEU, Charles Calomiris and Matthew Jaremski discuss the origins of bank liability insurance. They argue that it is redistribution, not the aim to boost efficiency, which explains a lot of the action.
… there are two theoretical approaches to explaining the creation and expansion of deposit insurance. The first is an economic approach grounded in potential efficiency gains from limiting bank runs (i.e. the public interest motivation). The second is a political approach grounded in the rising power of special interest groups that favoured insurance as a means to access subsidies (i.e. the private interest motivation).
… Because insurance reduces the incentive for market discipline, it may increase fundamental insolvency risk … whether, on balance, bank liability insurance reduces or increases risk … is an empirical question. Economic theories of liability insurance only make sense on economic grounds if the gains from liquidity risk reduction tend to exceed the moral hazard or adverse selection costs from reduced market discipline.
… Political models seek to explain why liability insurance may be chosen to favour certain groups in society even when it imposes large costs on society in the form of higher systemic risk for banks. In this context, liability insurance needs to be understood as part of an equilibrium political bargain achieved by a winning political coalition. …
… we review empirical evidence about, first, which factors are shown to be instrumental in creating bank liability insurance; and second, evidence about the consequences of passing insurance … We find that political theories are much more consistent with both sets of evidence.
… the historical push for liability insurance in the US came from a coalition of small rural bankers and landowning farmers …
Worldwide, bank liability insurance remained a unique (and controversial) policy choice of the US until the late 1950s, but it spread rapidly throughout the world in recent decades …
Like the adoption of liability insurance in the US, the recent global wave of legislation creating and expanding insurance can also be traced to political influences. …
The expansion of liability insurance has been generally associated with reductions in banking system stability …
The political theories of liability insurance point to a major political advantage. It provides an effective means for a government to supply hard-to-trace subsidies to particular classes of bank borrowers … agricultural borrowers or urban mortgage borrowers …
Liability insurance can create a subsidy for banks (which they can pass through, in part, to borrowers) only if prudential regulation and supervision permit banks to take risks at the expense of the insurer. Thus, lax regulation and supervision are an important part of the political bargain that allows liability insurance to deliver subsidies to banks and targeted borrowers. …
Lord King offers a novel alternative. Central banks would still act as lenders of last resort. But they would no longer be forced to lend against virtually any asset, since that very possibility must create moral hazard. Instead, they would agree the terms on which they would lend against assets in a crisis, including relevant haircuts, in advance. The size of these haircuts would be a “tax on alchemy”. They would be set at tough levels and could not be altered in a crisis. The central bank would have become a “pawnbroker for all seasons”.
The key part of this quote is “could not be altered in a crisis.” Central banks and governments have always found it very difficult to commit not to support systemically (or politically) important players ex post. This problem lies at the heart of many problems in the financial system and elsewhere. By assuming that central banks could commit under the proposed arrangement, the proposal abstracts from a key friction.
They have been increased. The illustration is taken from Finanz und Wirtschaft.
In his blog, John Cochrane points to SoFi, a FinTech company, as proof that banking services can be delivered by institutions without the traditional characteristics of a bank.
SoFi finances loans by selling equity. The loans are securitized and the cash is reinvested in loans. As John points out:
- A “bank” (in the economic, not legal sense) can finance loans, raising money essentially all from equity and no conventional debt. And it can offer competitive borrowing rates — the supposedly too-high “cost of equity” is illusory.
- There is no necessary link between the business of taking and servicing deposits and that of making loans. Banks need not (try to) “transform” maturity or risk.
- To the extent that the bank wants to boost up the risk and return of its equity, it can do so by securitizing loans rather than by borrowing. (Securitized loans are not leverage — there is no promise of your money back when you want it. Investors bear any losses immediately and without recourse.)
- Equity-financed banking can emerge without new regulations, or a big new Policy Initiative. It’s enough to have relief from old regulations (“FDIC-free”).
- Since it makes no fixed-value promises, this structure is essentially run free and can’t cause or contribute to a financial crisis.
The Economist reports about initiatives by commercial and central banks that aim at adopting the blockchain technology.
For commercial banks, distributed ledgers promise various advantages—but they also cause problems:
Instead of having to keep track of their assets in separate databases, as financial firms do now, they can share just one. Trades can be settled almost instantly, without the need for lots of intermediaries. As a result, less capital is tied up during a transaction, reducing risk. Such ledgers also make it easier to comply with anti-money-laundering and other regulations, since they provide a record of all past transactions (which is why regulators are so keen on them).
… Yet … [o]ne stumbling block is what geeks call “scalability”: today’s distributed ledgers cannot handle huge numbers of transactions. Another is confidentiality: encryption techniques that allow distributed ledgers to work while keeping trading patterns, say, private are only now being developed. … Such technical hurdles can be overcome only with a high degree of co-operation …
Meanwhile, central banks plan digital currencies built around the same technology.
Like bitcoin, these would be built around a database listing who owns what. Unlike bitcoin’s, though, these “distributed ledgers” would … be tightly controlled by the issuers of the currency.
The plans involve letting individuals and firms open accounts at the central bank …
Central banks … could save on printing costs if people held more bits and fewer banknotes. Digital currency would be tougher to forge, though a successful cyber-attack would be catastrophic. Digital central-bank money could even, in theory, replace cash. …
Better yet, whereas bundles of banknotes can be moved without trace, electronic payments cannot. … The technology first developed to free money from the grip of central bankers may soon be used to tighten their control.
Instead of taking commissions from customers, Robinhood receives them from the trading venues to which it steers their orders, a controversial but common practice. It also earns returns from the cash clients leave in their accounts, and plans soon to offer margin trading—the buying of stock with borrowed money—for which it will charge a fee.