Thursday, January 05, 2012

Not understanding banking is an impediment to regulating banks

MacroResilience demonstrates why not understanding banking is an impediment to regulating banks:
Amar Bhide’s idea essentially seeks to turn back the clock and forbid much of the innovation that has taken place in the last few decades... But it is not enough to mitigate the moral hazard problem... Let us assume that banks can only take deposits and make loans to corporations and households... Banks can simply lend to other firms that take on negatively skewed bets. You may counter that banks should only be allowed to lend to real economy firms. But do we expect regulators to audit not only the banks under their watch but also the firms to whom they lend money?
In a word--yes!

First, bank lending is capital constrained (not reserve constrained), so limits to leverage (especially derivatives, which hide leverage very well) are at the very core of regulation. When a bank makes a loan, the impact of that balance sheet expansion must be risk weighted. So, buying US Treasuries -- go nuts! Buying anything else -- you'll hit your cap earlier.

And yes, this means that regulators need to look at the loans banks are making. In fact, regulators cannot regulate without looking at the loans banks are making. This is baked into the Basel accords that specifically risk-weight capital requirements.

Second, if banks were also required to keep all their loans on their books, then they would have an incentive to make good credit decisions, something they are not motivated to do if they can offload risk to third parties.

Third, if counterparties failed, loans went bad, and banks went under, so long as the Fed gave the bank open access to the discount window and didn't shut it down when it fell under it's capital requirements, a bank with a negative equity position can continue to clear checks.

But, if you believe "unless short-term deposits are deployed to match long-term investment projects" then these regulatory options are inconceivable.


Blogger RomeoStevens said...

It is sad that this is noteworthy, but noteworthy it is. In fact I would go so far as to say that bank lending being capital constrained and not reserve constrained should be the official headline of the last decade. It does impart a lesson about history though. That even right on top of the events with unprecedented information at our fingertips we still trade in unhelpful narratives. Narratives handed down to us are if anything likely even less accurate.

4:25 PM  
Blogger Ralph Musgrave said...

Thanks for drawing attention to the MacroResiliance post. However, you say “And yes, this means that regulators need to look at the loans banks are making.” Winter: do you honestly think those hopelessly incompetent regulators are capable of passing judgement on those loans?

The regulators couldn’t figure out that Bernie Madoff was up to no good despite being told loud and clear ten years ago that he was a crook.

I prefer something along the lines of the solution advocated by MacroResilience and advocated here:

This is to make a clear distinction between bank deposits which customers want to be safe, and deposits where the depositor wants their money invested in commerce. The former money is deposited at the central bank (or invested in government bonds). That would be guaranteed by government. As to everything else, it would be a case of “you’re on your own, mate - if you lose everything, we, the government and taxpayer, don’t give a hoot: in the same way as we don’t give a hoot if you lose all your money to Bernie Madoff.”

11:45 PM  
Blogger NeilW said...


I think Steve Keen has the best response to the 100% reserve people:

'Technically, both these proposals would work. I won’t go into great detail on them here, other than to note my reservation about them, which is that I don’t see the banking system’s capacity to create money as the causa causans of crises, so much as the uses to which that money is put. As Schumpeter explains so well, the endogenous creation of money by the banking sector gives entrepreneurs spending power that exceeds that coming out of “the circular flow” alone. When the money created is put to Schumpeterian uses, it is an integral part of the inherent dynamic of capitalism. The problem comes when that money is created instead for Ponzi Finance reasons, and inflates asset prices rather than enabling the creation of new assets.'

'Schumpeterian banking also inherently includes the capacity to make mistakes: to fund a venture that doesn’t succeed, and yet to be willing to take that risk again in the hope of funding one that succeeds spectacularly. I am wary of the capacity of that mindset to co-exist with the bureaucratic one that dominates government.'

It's the speculation on asset prices and the nature of the private bank's "licence to print money" that is the issue, not the system itself.

Having the amount that can be issued on the licence linked to some capital amount is likely the target. That probably should be a fixed amount - which limits the size of the money creation banks and makes them more dynamic.

1:38 AM  
Blogger winterspeak said...

RALPH: Banks do not lend out deposits, therefore NO deposits are involved in commerce. But you do raise a good point, I should add that all deposits should be FDIC insured. The only money involved in commerce would be the equity that investors put into the bank. In the event of failure, those equity holders should be wiped out.

As MacroResiliance doesn't understand this, this solution evades him.

NEIL: Right. Horizontal money creation is not a problem. Getting paid even if loans aren't paid back is -- the primary purpose of banking is to direct investment using private money in first loss position.

Capital requirements, which is what you are talking about, are probably too low. But capital requirements also vary by loan risk (so you should need a lot of capital set aside for risky loans, and less set aside for safe loans, such as US Treasuries). This means that regulators, to assess whether banks are compliant with capital requirements or not, will need to look at the loans.

9:53 AM  
Blogger Ralph Musgrave said...


Thanks for the link to Steve Keen. The fractional versus full reserve argument is separate from the above “two types of deposit account” idea. E.g. one could have a fractional reserve system in which incorporated the above idea relating to 100% safe deposit accounts, far as I can see.

Re Steve Keen I basically agree with him. That is, the main fault in fractional reserve is the asset price bubbles it exacerbates. Milton Friedman favoured full reserve and I think primarily for that reason. (I had a copy of his book, “A Program for Monetary Stability” till recently: it went AWOL).

Limiting banks’ capital might do the trick: I hadn’t thought of that.

10:51 AM  
Blogger NeilW said...

100% safe deposit accounts is what National Savings is for.

Bring back the Post Office Account!

11:25 AM  
Blogger winterspeak said...

RALPH: No -- fractional reserve banking has nothing to do with asset bubbles. This is because banks do not lend out reserves.

You've spent a lot of time at MMT sites so it surprises me that you keep asserting this.

NEIL: I don't think Post Office accounts help here because of how balance sheets work out. When a bank makes a loan, that asset (receivable) must be balanced by a liability (deposit). If the deposits are kept in post office accounts, then a bank loan becomes a liability there instead, and somehow the post office account and the bank need to borrow or lend to each other via some other form of reserve account (which is how this is balanced between different banks today).

This is more opaque than simply declaring all deposits to be 100% FDIC insured, and wiping out investors (equity holders) when loans go bad.

Since banks do not loan out deposits, nor do deposits capitalize banks, it makes no sense to think of savers as any class of investor.

3:18 PM  
Blogger scharfy said...

Just an utterly important post.

Understanding this key point, that banks 'originate' loans, in the rawest sense of the word - and DO NOT transfer money from savers to borrowers is all powerful. Without that crucial concept truly internalized, you can't visualize the architectural foundation around which our economy is built.

And obviously policy / regulation becomes laughably(sadly) impotent if you dont get this.

After you truly swallow that pill, all the mental dominoes begin to fall and the music plays, birds sing, etc, etc...

You see that banks don't put money to work, and that reserve requirements become less, or totally irrelevant and so on and so on.

Vertical/horizontal money become obvious and the pieces fall right into place.

Thanks for a Gem of a blog. Doing 'God's work' - to borrow a phrase I heard somewhere.

11:50 PM  
Blogger NeilW said...

" If the deposits are kept in post office accounts, then a bank loan becomes a liability there instead, "

I little UK history here.

The 'Post Office Account' was a National Savings Account operated by the Post Office on behalf of National Savings (which used to be called the Post Office Savings Bank) - which is an arm of the government. The UK Post Office is a nationalised company.

Therefore when you used to put money in an old style UK Post Office Savings Account it was pretty much the same as buying a UK government bond. (In fact you used to be able to buy Gilts via National Savings).

The money goes into the government's account at the Bank of England (ie vanishes in MMT terms) and your account is marked up at National Savings.

So in MMT terms moving money to a UK style 'Post Office Savings Account' reduces the central bank reserves at the private bank on the asset side, and the customer deposit on the liability side.

I was very fond of my little blue passbook as a kid.

12:09 AM  
Blogger Greg said...


"Understanding this key point, that banks 'originate' loans, in the rawest sense of the word - and DO NOT transfer money from savers to borrowers is all powerful. Without that crucial concept truly internalized, you can't visualize the architectural foundation around which our economy is built."

Agree completely but then the next question asked (at least I did!) is;
So what exactly are banks lending you if they ARENT lending you someone elses savings?

After some thought the answer I came up with is that they are lending me MY OWN future income. Im just pre-spending a portion of my future income and the bank gives me a lump some of an agreed upon amount.

What happens when I fail to keep my income stream going? Well the bank comes and takes something else of mine or/and they go to the govt and get some money to cover their losses. What almost never happens is that the bank equity holders fall into their first loss position. That part is a frikken ruse of epic proportions.

5:51 AM  
Blogger beowulf said...

There was a similar United States Postal Savings System from 1911 to 1967.

There's no reason the Post Office couldn't lend as well as accept deposits (deposits would flow into Tsy and mortgages would flow out). Just contract out lending operations to USAA, a rather phenomenal little bank for military families (just read its now open to non-military, I might open an account) that has exactly 0 branches. It has $43 billion in deposits and everything is run out of its San Antonio TX office online and on the phone. Now that is a scalable business model!

I imagine the American Banking Association would collectively stroke out. :o)

1:37 AM  
Blogger winterspeak said...

NEIL: Makes sense, but that means there still needs to be a connection between the post office account, bank, and central bank (via reserve accounts). This is the same as having 100% FDIC insurance on deposit accounts in our current structure.

GREG: Banks print money out of thin air and lend it out. That money gets paid back (or not) but at the moment of creation, it comes from nothing.

BEOWULF: If the post office lent as well as accepted deposits, it would be a retail bank, and then the questions becomes, are the loans being made prudent? To the extent that the equity holders in the post office would be the Government, I don't see why they would be good stewards of investment decisions.

USAA is great, but what makes them great is the creditworthiness of their customers. There are lots of opportunities for small scale lenders to use their deep knowledge of a community to make better credit decisions. The original exotic mortgage loans, IIRC, came from a bank specializing in loaning money to recent immigrant cab drivers. Although these people had no official credit history, people in their community knew who was trust worthy and who was not, and the loan was structured to work well in this situation.

9:36 AM  
Blogger Greg said...

I understand that banks create money out of thin air but its also true that the value of that loan is "backed" by the income of the borrower is it not?

If you think of it like currency being backed by something (gold/taxes), bank loans are backed by borrowers incomes. Maybe thats an uninteresting observation but it is counter to the idea that a banks loans are backed by reserves or deposits or someone elses savings.

6:57 PM  
Blogger winterspeak said...

GREG: Loans are "backed" by whatever collateral secures the loan. This might be the house in the case of the mortgage, or the vehicle in the case of a car loan.

The likelihood of it being repaid is dependent on the borrowers willingness and ability to repay, and the bank's interest in and ability to collect.

"Backed" suggests that the bank has to have some "backing" before it can make the loan. As we've all seen, the borrower's income is clearly *not* backing, as banks were happy making loans to people with no income. The only requirement for a bank is that it has adequate capital reserves. If you're looking for "backing", that's it.

8:21 PM  
Blogger Nichole said...

What I like with my bank is that they clearly outline the features and benefits of my bank account. And they also clarify complicated issues, like how we work out bank rates and fees and what happens when you overdraw. And another thing is the relationship banking that we have.

9:18 PM  

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