Tag Archives: Short-term debt

“Toward a Run-Free Financial System”

In the tenth chapter of “Across the Great Divide: New Perspectives on the Financial Crisis,” John Cochrane argues that at its core, the financial crisis was a run and thus, policy responses should focus on mitigating the risk of runs (blog posts by Cochrane on the same topic can be found here and here). Some excerpts:

… demand deposits, fixed-value money-market funds, or overnight debt … [should be] backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. …

Banks can still mediate transactions, of course. For example, a bank-owned ATM machine can deliver cash by selling your shares in a Treasury-backed money market fund … Banks can still be broker-dealers, custodians, derivative and swap counterparties and market makers, and providers of a wide range of financial services, credit cards, and so forth. They simply may not fund themselves by issuing large amounts of run-prone debt.

If a demand for separate bank debt really exists, the equity of 100 percent equity-financed banks can be held by a downstream institution or pass-through vehicle that issues equity and debt tranches. That vehicle can fail and be resolved in an hour …

Rather than outlawing short-term debt, Cochrane suggests to levy corrective taxes on run-prone liabilities. Moreover:

… technology allows us to overcome the long-standing objections to narrow banking. Most deeply, “liquidity” no longer requires that people hold a large inventory of fixed-value, pay-on-demand, and hence run-prone securities.

… electronic transactions can easily be made with Treasury-backed or floating-value money-market fund shares, in which the vast majority of transactions are simply netted by the intermediary. … On the supply end, $18 trillion of government debt is enough to back any conceivable remaining need for fixed-value default-free assets.

Cochrane rejects the claim that the need for money-like assets can only be met by banks that “transform” maturity or liquidity. He argues that current regulation reflects a history of piecemeal responses that triggered the need for additional measures; and he points out that the shadow banking system creates run risks because a “broker-dealer may have used your securities as collateral for borrowing” to fund proprietary trading.

Cochrane debunks crisis lingo and clarifies links between aggregate variables:

The only way to consume less and invest less is to pile up government debt. So a “flight to quality” and a “decline in aggregate demand” are the same thing.

He questions the need for fixed value securities other than short-term government debt as means of payment or savings vehicle; offers a short history of financial regulation; and deplores regulatory discretion.