Tag Archives: Reserves

Costs and Benefits of Unconventional Monetary Policy

The BIS has issued two reports that assess the implications of unconventional monetary policies.

The report prepared by the Committee on the Global Financial System discusses

… a number of unconventional monetary policy tools (UMPTs). After a decade of experience with UMPTs the report takes stock of central banks’ experience and draws some lessons for the future.

The report focuses on four sets of tools: negative interest rate policies, new central bank lending operations, asset purchase programmes, and forward guidance. It offers a summary of central banks’ shared understanding of the efficacy of these tools across countries, as well as the way that they were sequenced and coordinated.

The report concludes that, on balance, UMPTs helped the central banks that used them address the circumstances presented by the crisis and the ensuing economic downturn. It identifies side effects, such as dis-incentives to private sector deleveraging and spillovers to other countries, but does not consider them sufficiently strong to reverse the benefits of UMPTs.

The report also discusses whether, and under what circumstances, these tools could be useful in the future. Central banks report that the tools have earned a place in the monetary policy toolbox, but they also highlight that their use should be accompanied by measures that mitigate their potential side-effects. They also highlight that under the circumstances when the tools can be helpful, they need to be used in decisively but in a context that includes a wider set of policies as to avoid overburdening the central bank.

The report prepared by a Markets Committee study group argues that

… some balance sheet-expanding policies were specifically aimed at improving market functioning, and that they delivered on this front. The potential for adverse side effects arose most clearly at a later stage, when asset purchase programmes were introduced to provide monetary stimulus at the effective lower bound for interest rates. But side effects rarely tightened financial conditions in markets to a point that would have undermined policy effectiveness.

That said, the report finds that some market malfunctioning did arise. In bond markets, adverse effects were mostly associated with asset scarcity, but any such effects were often temporary, in part due to mitigating policies. In money markets, market functioning issues (for example in interbank reserve trading) arose from the abundance of reserves. Yet, other wholesale money markets remained robust and central banks retained sufficient control over short-term rates, typically by introducing new tools. The report acknowledges that prolonged use of large balance sheet policies may have longer-term adverse effects on the market ecosystem, but these are hard to measure at this point.

“Reserves For All? Central Bank Digital Currency, Deposits, and their (Non)-Equivalence,” IJCB

Accepted for publication in the International Journal of Central Banking. PDF.

This paper offers a macroeconomic perspective on the “Reserves for All” (RFA) proposal to let the general public hold electronic central bank money and transact with it. I propose an equivalence result according to which a marginal substitution of outside money (e.g., RFA) for inside money (e.g., deposits) does not affect macroeconomic outcomes. I identify key conditions for equivalence and argue that these conditions likely are violated, implying that RFA would change macroeconomic outcomes. I also relate the analysis to common arguments found in discussions on RFA and point to inconsistencies and open questions.

“Reserves For All? …” on Several SSRN Top Ten Lists

My July 2018 CEPR working paper “Reserves For All? Central Bank Digital Currency, Deposits, and their (Non)-Equivalence” has made it on several SSRN top ten lists. PDF. (Personal copy.)

Abstract: I offer a macroeconomic perspective on the “Reserves for All” (RFA) proposal to let the general public use electronic central bank money. After distinguishing RFA from cryptocurrencies and relating the proposal to discussions about narrow banking and the abolition of cash I propose an equivalence result according to which a marginal substitution of outside for inside money does not affect macroeconomic outcomes. I identify key conditions on bank and government (central bank) incentives for equivalence and argue that these conditions likely are violated, implying that RFA would change macroeconomic outcomes. I also relate my analysis to common arguments in the discussion about RFA and point to inconsistencies and open questions.

“Reserves For All? Central Bank Digital Currency, Deposits, and their (Non)-Equivalence,” CEPR, 2018

CEPR Discussion Paper 13065, July 2018. PDF. (Personal copy.)

I offer a macroeconomic perspective on the “Reserves for All” (RFA) proposal to let the general public use electronic central bank money. After distinguishing RFA from cryptocurrencies and relating the proposal to discussions about narrow banking and the abolition of cash I propose an equivalence result according to which a marginal substitution of outside for inside money does not affect macroeconomic outcomes. I identify key conditions on bank and government (central bank) incentives for equivalence and argue that these conditions likely are violated, implying that RFA would change macroeconomic outcomes. I also relate my analysis to common arguments in the discussion about RFA and point to inconsistencies and open questions.

“Für elektronisches Zentralbankgeld (In Favor of Central Bank Digital Currency),” NZZ, 2018

NZZ, March 15, 2018. PDF. Ökonomenstimme, March 19, 2018. HTML

  • CBDC is not the same as krypto currencies.
  • The case against CBDC is not at all obvious; CBDC has costs and benefits.
  • Switzerland should not dismiss CBDC too quickly.
  • (The title of the article is misleading, it is not mine. I argued for openness in the discussion rather than for adoption.)

Desirable Features of Central Bank Issued Digital Currency

On bankunderground, Simon Scorer reminds us that a central bank issued digital currency (CBDC) need not operate on a distributed ledger platform. The two do not have much to do with each other.

Scorer suggests a series of technical requirements for a CBDC:

And he concludes that a distributed ledger does not meet all requirements.

It’s unlikely that all of the above attributes could be perfectly met with today’s technology; you may need to make compromises between features – e.g. the trade-off between resilience and privacy …

CBDC is far from just a simple question of technology; any central bank contemplating CBDC will need to answer a host of fundamental economic questions, as well as considering how feasible it is to achieve all the required features and what type of technology might enable this.

“Kunden sollten zwischen Sichtguthaben und elektronischem Notenbankgeld wählen können (Let People Choose Between Deposits and Reserves),” NZZ, 2017

NZZ, August 17, 2017. HTML, PDF. Longer version published in Ökonomenstimme, August 21, 2017. HTML.

  • The Vollgeld initiative may point to a problem but it does not propose a viable solution.
  • Even with Vollgeld, the time consistency friction with its Too-Big-To-Fail implication would persist.
  • A more flexible, liberal approach appears more promising.
  • It would give the general public a choice between holding deposits and reserves.
  • Financial institutions and central banks around the world are pushing in that direction.

“Die Vollgeld-Initiative und eine Alternative (The Swiss Sovereign Money Initiative, and an Alternative),” SNB, 2017

In: Thomas Moser, Carlos Lenz, Marcel Savioz and Dirk Niepelt, editorial committee, Monetary Economic Issues Today, Festschrift in Honour of Ernst Baltensperger, Swiss National Bank/Orell Füssli, Zürich, June 2017. PDF of draft.

The sovereign money initiative (Vollgeldinitiative) seeks to gain greater control over the money and credit supply, to increase financial stability and to achieve a fairer distribution of seigniorage income. The initiative’s suggested approach – a ban on active money creation – is inefficient and may even prove ineffective, as it fails to address the core problems. A variant of the initiative, which would allow the public access to electronic central bank money on a voluntary basis, would offer greater benefit at lower cost.

Fintech Regulation in Switzerland: Open Questions

In the NZZ, Jürg Müller reports about the developing regulatory framework for fintechs in Switzerland. A proposal by the federal finance department drew—reasonable—criticism by various lobbies and industry associations, including the CFA Society Switzerland.

Die CFA Society Switzerland will das systemrelevante Bankensystem von anderen Finanzdienstleistern trennen. Dafür sei eine präzisere Bankendefinition nötig, als sie heute vorgenommen werde. Nur Banken sollen demnach dem Bankengesetz unterstehen. Finanzdienstleister, die kein traditionelles Bankengeschäft betreiben und keine Liquiditätsrisiken eingehen, sollen einem anderen Regulierungsmodell unterstehen. Dabei sollen je nach Tätigkeit unterschiedliche funktionale Lizenzen zum Zuge kommen – dieser letzte Punkt wird von vielen Vernehmlassungsteilnehmern ebenfalls eingefordert.

Schliesslich identifiziert die CFA Society Switzerland auch zentrale Fintech-Themen, die in der Vernehmlassung aussen vor gelassen wurden. Eine dieser Lücken sei der direkte Zugang zur Schweizerischen Nationalbank (SNB). Aus heutiger Sicht sei nicht ersichtlich, weshalb nur Banken elektronisches Zentralbankgeld halten dürften. Auf Anfrage wollte die SNB zu dieser Forderung keine Stellung nehmen. Andere Zentralbanken wie die Bank of England zeigen sich solchen Ideen gegenüber derweil aufgeschlossen. Auch einzelne Schweizer Ökonomen wie beispielsweise Dirk Niepelt stehen allgemein zugänglichem elektronischem Notenbankgeld positiv gegenüber.

Link to my article mentioned above.

How Problematic Is a Large Central Bank Balance Sheet?

On his blog, John Cochrane reports about a Hoover panel including him, Charles Plosser, and John Taylor.

Cochrane focuses on the liability side. He favors a large quantity of (possibly interest bearing) reserves for financial stability reasons. Plosser focuses on the asset side and is worried about credit allocation by the Fed, for political economy reasons. Taylor favors a small balance sheet. Cochrane also talks about reserves for everyone, but issued by the Treasury.

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).

Banking on the Blockchain

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.

New possibilities:

  • 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.

Challenges:

  • Speed; scalability; security;
  • privacy;
  • 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?

Should the Fed Reduce the Size of its Balance Sheet?

On his blog, Ben Bernanke discusses the merits of the Fed’s strategy to slowly reduce the size of its balance sheet to pre crisis levels. Bernanke (with reference to a paper by Robin Greenwood, Samuel Hanson and Jeremy Stein) suggests that this strategy should be reconsidered:

First, the large balance sheet provides lots of safe and liquid assets for financial markets. This might strengthen financial stability. (DN: In my view, there are also reasons to expect the opposite.)

Second, a larger balance sheet can help improve the workings of the monetary transmission mechanism, in particular if non-banks can deposit funds at the Fed. Currently, the Fed accepts funds from private-sector institutional lenders such as money market funds, through the overnight reverse repurchase program (RRP). (DN: I agree. As I have argued elsewhere, access to central bank balance sheets should be broadened.)

Third, with a large balance sheet and thus, large bank reserve holdings to start with, it could be easier to avoid “stigma” in the next financial crisis when banks need to borrow cash from the Fed but prefer not to in order not to signal weakness. (DN: Like the first, this third argument emphasizes banks’ needs. In my view, monetary policy should not emphasize these needs too much because it is far from clear whether bank incentives are sufficiently aligned with the interests of society at large.)

Bernanke also discusses the reasons why the Fed does want to reduce the balance sheet size.

First, in a financial panic, programs like the RRP could result in market participants depositing more and more funds at the Fed until the interbank market would be drained of liquidity. But these programs could be capped.

Second, a large balance sheet increases the risk of large fiscal losses for the Fed and thus, the public sector. Losses could trigger a legislative response and undermine the Fed’s policy independence. But these risks could be kept in check if the Fed invested in government paper that constitutes a close substitute to cash, such as three year government debt. (DN: But why, then, shouldn’t financial market participants hold three year government debt rather than reserves at the Fed? Because cash is much more liquid than government debt … But what does this mean?)

Reserves For Everyone

On a new website, Aleksander Berentsen rejects the Swiss Vollgeld initiative. As an alternative, he suggests the Swiss National Bank should offer transaction accounts for everybody, in line with proposals I have made earlier (see here (2016), here (2015), here (2015)).

In the Handelszeitung (here and here), Simon Schmid reports.

“Elektronisches Notenbankgeld ja, Vollgeld nein (Reserves for All, But no Sovereign Money),” NZZ, 2016

Neue Zürcher Zeitung, June 16, 2016. PDF, HTML. Ökonomenstimme, June 17, 2016. HTML.

  • Vollgeld seems attractive because it decouples the supply of money from intermediation. By enabling everyone to use legal tender for electronic payments, electronic base money would satisfy a need.
  • Vollgeld would prevent bank runs, at least partly; render deposit insurance unnecessary and reduce moral hazard; could help stabilize the credit cycle; and would redistribute seignorage to the central bank.
  • But these objectives can be obtained with less intrusive means.
  • Moreover, a Vollgeld system would be hard to enforce. Banks and their clients would establish new means of payment to circumvent the regulation. And in times of crisis, the central bank would feel obliged to provide liquidity assistance and bail outs.
  • The central problem is not that private money is used for transactions; it rather is that the money’s users rely on the central bank to guarantee the substitutability of private money and base money. In a democracy, the central bank cannot credibly let large parts of the payment system go under.
  • A sudden, forceful change of regime does not offer a credible way out of this trap.
  • But letting the general public access central bank reserves without abolishing private money from one day to the other may open a path towards a new arrangement where the public learns to distinguish between private and base money and where only the latter is publicly guaranteed.

Blockchains in Banking (Commercial and Central)

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.

I Would Like to Withdraw A Couple Billion Swiss Francs: Legal Aspects

On his blog, Urs Birchler offers different perspectives on the question whether the Swiss National Bank (SNB) is obliged to pay out banks’ reserves in cash.

  • One view: Reserves are legal tender. The SNB therefore is not obliged to exchange reserves against cash.
  • Another view: According to the law, the SNB is required to provide sufficient cash. Moreover, reserves and cash were meant to be perfect substitutes.
  • Yet another view: Lawmakers would have written a different law had they known that the SNB considers it necessary to impose negative interest rates.

Mervyn King on Narrow Banking and Liquidity Insurance

In the FT, John Plender reviews Mervyn King’s “The End of Alchemy: Money, Banking and the Future of the Global Economy.” King diagnoses two problems underlying the crisis. First,

Interest rates today, he says, are too high to permit rapid growth of demand in the short run but too low to be consistent with a proper balance between spending and saving in the long run. The disequilibrium persists, as does a misallocation of capital to unproductive investments.

The second problem relates to the financial system and

the alchemy that runs through the financial system, whereby governments pretend that paper money can be turned into gold on demand and banks pretend that the short-term deposits used to finance long-term investments can be returned whenever depositors want their money back. …

King argues that Bagehot’s famous dictum on central bank crisis management — lend freely on good collateral at penalty rates — is out of date because bank balance sheets today are much larger and have fewer liquid assets than in the 19th century. Central banks are thus condemned in a crisis to take bad collateral in the shape of risky, illiquid assets on which they will lend only a proportion of the value, known as a haircut.

King suggests this lender of last resort role should be replaced by … a pawnbroker for all seasons. In effect, he offers an elegant refinement of the concept of “narrow banking”, which seeks to ensure that all deposits are covered by safe, liquid assets. In his system, banks would decide how much of their asset base to lodge in advance at the central bank to be available for use as collateral. For each asset, the central bank would calculate a haircut to decide how much to lend against it. Together with banks’ cash reserves at the central bank, this collateral would be required to exceed total deposits and short-term borrowings.

This central bankerly pawnbroking would facilitate the supply of liquidity, or emergency money, within a framework that eliminates the incentive for bank runs. It amounts to a form of insurance whereby the central bank can lend in a crisis on terms already agreed and paid for upfront …

The system would displace what King regards as a flawed risk-weighted capital regime ill-suited to addressing radical uncertainty. Today’s liquidity regulation would also become redundant. But banks would still need an equity buffer, with King seeing an equity base of 10 per cent of total assets as “a good start”, against the 3-5 per cent common today.

The current shortfall of fully liquid assets against deposits — the alchemical gap — could be eliminated progressively over 20 years, during which time the expectation would grow that banks would no longer be bailed out. The system would apply to all financial intermediaries …

Update: The Economist‘s reviewer writes:

… Lord King wants banks to buy “liquidity insurance”. In normal times banks would pledge collateral to the central bank, which would agree to lend a certain amount against it, if necessary. Banks would thus know in advance precisely how much help they could get in the event of a meltdown, making them behave responsibly when times were good.

Central Bank Reserves: Debt vs. Equity

In jusletter.ch, Corinne Zellweger-Gutknecht argues that the legal status of central bank reserves is more equity- than debt-like—at least as far as the Swiss National Bank (SNB) is concerned. According to Zellweger-Gutknecht, reserves constitute debt only if the SNB is legally obliged to redeem them in exchange for central bank assets.

If the SNB purchases dollars against Swiss Francs in an open market operation, it creates reserves which are equity-like. But if it acquires dollars against Swiss Francs and is committed to engage in a reverse transaction in the future (a swap), then it (temporarily) creates reserves which are debt-like.