Tag Archives: Capital requirement

How Does the Blockchain Transform Central Banking?

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).

Sovereign Debt in Bank Balance Sheets

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.

Binswanger’s “Money Out of Nothing”

In his recent book Geld aus dem Nichts (Money out of Nothing), Mathias Binswanger discusses the role of banks in creating money, and money’s role in affecting the macro economy. The book is written for a non specialist audience and the arguments are often quite loose.

In the first part of the book, Binswanger describes how money mostly is created by commercial rather than central banks.

Part II provides a nice historical overview. Binswanger describes the origins of modern banking with goldsmiths first storing gold for their merchant clients, then lending some of the stored gold to third parties, and finally issuing more “receipts” than what corresponds to the gold deposits they actually accepted. From there, he argues, it was a small step to state licensed national banks like the Bank of England. On p. 120 Binswanger describes how minimum reserve requirements got out of fashion, not least because they suffered from circumvention when they were binding.

Part III lacks precision and is misguided (see also pp. 30 or 66). It covers the link between money creation and growth but confuses national accounting concepts and their relation to money and credit. Clearly, growth can occur without credit (think of an economy with just one agent to see this most directly) but Binswanger seems to dispute this point, in line with earlier writings by his father. A “model” on p. 144 does not help to clarify his views because it is orthogonal to the argument. Binswanger criticizes mainstream economics for refusing to accept the presence of long-run links between money and growth but this critique remains vain. Part IV deals with money creation and its effect on financial markets.

Part V, on reform, is sensible. Binswanger rejects proposals to move (back) to the gold standard or a 100%-money regime (or, essentially equivalent, “positive money”). His arguments against the Swiss “Vollgeld” initiative resonate with points I made here and elsewhere, including the point that it would be difficult to enforce a “Vollgeld” regime (see also p. 122). Binswanger criticizes the “Vollgeld” initiative’s vagueness concerning actual implementation of monetary policy. He ends with more limited, rather standard proposals (relating to regulation, monetary policy objectives and capital requirements) to address problems in financial markets.

“How Is the System Safer? What More Is Needed?”

In the ninth chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” Martin Baily and Douglas Elliott argue that significant progress has been made in safeguarding financial stability:

  • Due to higher bank capital requirements, the FDIC can intervene before equity is wiped out.
  • Liquidity requirements work in the same direction and render fire sales less likely.
  • Easier resolution of distressed financial institutions helps to shield taxpayers when a bank fails.
  • Better macro prudential oversight helps to manage systemic risks.

The authors discuss these dimensions in much detail.

ECB Bank Stress Test

Claudia Aebersold Szalay reports in the NZZ on the findings of the stress test conducted by the ECB. The article contains a map and tables.

The ECB downgraded the quality of bank assets (mostly bad loans) relative to banks’ own estimates. This is reflected in lower estimates of banks’ equity positions. Moreover, the ECB conducted a stress test and considered two scenarios. According to the adverse one, banks’ equity positions would fall by more than 250 billion Euros. Italy, France and Germany would be hit hardest.

Claire Jones and Alice Ross as well as Martin Stabe offer additional insights in the FTFT. A report in the FAZ. The ECB‘s page with press release and other information.

Conference on “Law and Economics” with Focus Session on “Bank Resolution” at the Study Center Gerzensee

Joint with CEPR, the Study Center Gerzensee organised a conference on law and economics. The program can be viewed here and papers can be downloaded from CEPR’s website. The focus session on bank resolution featured contributions by

  • Patrick Bolton and Jeffrey Gordon (paper)
  • Martin Hellwig (paper, slides)
  • Mathias Dewatripont (slides)
  • Gerard Hertig
  • Wolf-Georg Ringe (paper)
  • Paul Tucker (paper)

In his talk, Jeff Gordon explained how Dodd-Frank extends the FDIC’s resolution technology from the 1930s to “non-banks” that engage in banking business. Dodd-Frank establishes an “Orderly Liquidation Authority” and in title II a “Single Point of Entry” by putting a holding company (topco) into receivership. The objective is to minimise disruption costs for large institutions, to preserve the going-concern value of the company and to avoid collateral damage. Single point of entry also helps resolve cross-border issues. No comparable institutional framework is available in the EU. In the crisis, US authorities implemented ad-hoc alternatives to bankruptcy: Mergers (which require the approval of shareholders and therefore make it hard to wipe out the target’s shareholders) worked for Bear Stearns (JPMorgan Chase, Maiden Lane, Fed) but not for Lehman Brothers (Barclays, Fed) because the UK authorities refused to waive Barclays shareholder approval, fearing fiscal implications. Recapitalisation with third party funds (Fed) in the case of AIG also required shareholder approval and protected creditors and counter-party claims.

Patrick Bolton cautioned that the rules for the topco are still not clear and discussed alternatives to Dodd-Frank in the bankruptcy code. He emphasised the role of qualified financial contracts and debtor-in-possession interventions.

Martin Hellwig argued that the government rescue of Hypo Real Estate reflected the political will to help influential creditors rather than systemic importance. He questioned the viability of single-point-of-entry arrangements in cross-border resolution, pointing to lack of trust among national regulators. He questioned whether internationally active banks can ever be resolved in an efficient manner and asked whether, in that light, they are socially valuable.

Mathias Dewatripont warned that excessive emphasis on bail-in arrangements can undermine financial stability, for example by having the expectation of a small haircut applied to senior debt tranches trigger a run on all senior debt. To avoid such an outcome, he favoured a clearly identified seniority structure with a significant balance-sheet share of “bail-inable” liabilities. He questioned the usefulness of higher capital requirements, arguing that “prompt corrective action” is politically infeasible unless the equity ratio has fallen below a very low value, 2 percent say.

Wolf-Georg Ringe favoured holding-company structures with sufficient “bail-inable” debt.

Paul Tucker discussed potential problems with the holding-company/single-point-of-entry strategy, related to centralised operations (IT). He raised the issue of accountability and the potential lack thereof if companies are resolved by regulators rather than judges, and he wondered whether national regulators can commit to collaborate across borders if need be. He favoured “bail-inable” debt over equity because the former gives incentives to monitor without the incentive to speculate on the upside.

Gerard Hertig warned that regulatory incentives lead to bank mergers rather than resolution, in particular because authorities tend to be more lenient in crisis times. He argued that because of deposit insurance, resolution worked well in Japan until recently.

Patrick Bolton argued that cocos are badly designed as their triggers are too low and they refer to accounting equity. Instead, he favoured reverse convertible bonds that can be converted by the issuer.

Oliver Hart argued that resolution has the advantage over cocos that the management gets replaced.

Many panelists voiced scepticism towards narrow banking proposals. They feared that control over the money supply might turn into control over credit, referring to the discussion in the US during the 1930s.