Monday, October 22, 2012

Analogy by Reason

SRW, whom I am fond of, has a long piece here about how there should be small, frequent financial failures so we can avoid large, systemic financial failures. The reasons for this are 1) we cannot beleive the law, since it is inevitably suspended when things go pear-shaped and 2) this is how forest fires are best managed.

On board with 1. But I don't think arboreal analogies are the best way to think about robust regulation.

One needs to look more carefully at the function of a bank, and see that they are at the intersection of two distinct activities. Muddling the actors in these two activites, and ignoring the correct role of Government, leaves you in a horrible pickle where you curse FDIC insurance and argue that Grannie should pay for Blankfein's sins. I exaggerate, but not by that much.

The two activities are 1) payment clearance and 2) credit decisions.

When I write a check to you, I want that check to clear if I have money in the account. My depositing money in a bank is not an investment decision where I am, or should, consider the credit worthiness of the institution. If I were buying stocks or commercial paper it's a different story, but depositors are fundamentally not bank creditors (even though the deposits themselves are held as liabilities) and should not bear the burden that falls on investment. Aside from this being true, it is also good policy. If we can separate picking stocks from being able to use a safe, reliable payment clearance system, we should, just as we should separate drinking water from sewage. This is half-done by FDIC insurance today, which insulates depositors, but not infinitely. Depositors should get unlimited coverage.

A bank makes a credit decision when it decides to make a loan. It does not use depositor's deposits to make that loan, it just prints the money by expanding both sides of its balance sheet, leveraging the capital cushion of its equity. If the loan goes well, it enriches those capital holders. If the loan goes badly, it should punish those capital holders. When capital holders decide to invest in a credit making institution, they are explicitly making a judgement call on the ability of that institution to make good credit decisions. These folks should be in first loss positions when a bank needs to write down its portfolio.

10 Comments:

Blogger Ralph Musgrave said...

I don’t agree with the blanket assertion in the last paragraph above that when banks make loans all the money comes from thin air. Certainly the commercial bank system CAN DO THAT. And it was doing it big time before the crunch. In contrast, over the last two years or so broad money has scarcely expanded at all, due to deleveraging. I.e. over the last two years, loans have come from depositors, not from thin air.

The last sentence of your article says that bank shareholders “should be in first loss positions when a bank needs to write down its portfolio”. Yes, of course. But the big problem that arose during the crunch (and which occurs on regular basis with smaller banks even in non-crunch times) is that shareholders’ stake in banks just isn’t big enough to absorb total losses. And that in turn means that depositors (i.e. “Grannie” as you put it) has to bear the loss. But we as a society can’t bear to see Grannies being robbed: so we introduce FDIC insurance.

But there’s a problem there: that insurance amounts to a subsidy. And what are we doing subsidising an industry which is supposed to be commercially viable?

So what’s the solution? Well, it’s easy. It’s thus.

Bar depositors from having their cake and eating it. That is, at the moment depositors can enjoy the benefits of commercial activity (having their money loaned on or invested) while being absolved of the risk inherent in lending / investing. That’s a nonsense.

Depositors should be made to come clean: they should have to decide between their money being 100% safe, in which case it is NOT INVESTED and they get no interest. Or alternatively, having their money invested / loaned on, in which case they carry the loss if it all goes wrong, but they DO GET interest. And that’s called “full reserve banking”. For more details see Laurence Kotlikoff’s work or:

http://www.positivemoney.org.uk/wp-content/uploads/2010/11/NEF-Southampton-Positive-Money-ICB-Submission.pdf


10:11 PM  
Blogger Neil Wilson said...

"Bar depositors from having their cake and eating it."

Except that you can't. The dynamics of banking won't let you do that.

Attempting to fix the amount of money in circulation failed in the 1980s. Trying to do it again via the back door will lead to precisely the same effects. Instability and chaos until the experiment is abandoned.

Money is naturally endogenous. It comes and goes from nothing, and never comes from depositors no matter how much you close your eyes and wish hard.

12:19 AM  
Blogger Ralph Musgrave said...

Neil,

The “have your cake and eat it” point is entirely separate from the arguments over 1980s style monetarism. The “cake” point is (to repeat) is that depositors who want to act in a commercial manner (i.e. have their money loaned on or invested by a bank) should bear the normal risks (downside and upside) of commercial activity. I don’t see much wrong with that requirement. Does anyone else?

Re the idea that full reserve equals 1980s style monetarism, the two are entirely different. Monetarism was the idea that the best way to regulate the economy (inflation and unemployment in particular) was to have a steady annual increase in the money supply. As you rightly say, that didn’t work. In contrast full reserve is the idea that loans should only be made using an existing stock of money – i.e. the money should not be created out of thin air by commercial banks.

As to whether the total stock of money (which under full reserve is controlled by government and central bank) is increased at a steady rate or increased / reduced in a more discretionary manner, that’s a separate issue. But as it happens, one major group advocating full reserve in the UK (Positive Money, Prof. Richard Werner & Co) claim that changes in the stock of money should be DISCRETIONARY. As to other advocates of full reserve, e.g. Prof. Laurence Kotlikoff, the authors of a recent IMF paper on the subject (Jaromir Benes and Michael Kumhof), William F.Hummel, Mish, etc, etc, etc, I haven’t checked up on what their views are on the “discretion” point.


Re your claim that “Money is naturally endogenous.”, that just begs the question. It’s true that there are market forces that bring privately created money into existence. But the question at issue here is whether we OUGHT TO continue to let those market forces operate.

I penned an article recently on the above full reserve / monetarist point here:

http://www.positivemoney.org.uk/2012/10/does-full-reserve-banking-equal-monetarism/

BTW I just noticed there are 68 comments after it. Dealing with that should keep me occupied for the next 48 hours:-)


5:12 AM  
Blogger Neil Wilson said...

"claim that changes in the stock of money should be DISCRETIONARY."

In other words via government sector spending injections - which is of course where the real effect happens.

What is missing of course is the mechanism for discretion when they need to withdraw money from the economy. Your Southampton paper is remarkably silent on that point - probably because they would then have to use the word 'tax'.

"But the question at issue here is whether we OUGHT TO continue to let those market forces operate."

You don't have any choice if you leave financial institutions as intermediaries. Banks buffer. It is their nature.

6:11 AM  
Blogger winterspeak said...

Ralph: I don't agree. If a bank goes out of business, investors (equity holders and bond holders) are large enough to bear the entire cost of the failure. Worst case: equity holders get completely diluted, and bond holders hold 100% of the equity, to liquidate or whatever as they wish.

That didn't happen. Neither equity holders nor bond holders were wiped out.

Whether or not a depositor earns any interest on the money they park at a bank has nothing to do with whether that money is being invested in any sense, or represents a speculative position in that particular institution. It is not, and it does not. Interest is merely one other mechanism by which banks try to attract deposits -- perks, such as good services, multiple branch locations, are others. All represents cost to a bank, but it is clearly nonsense to say that if a bank offers a convenient ATM network, anyone depositing money at that bank is more of an investor than anyone depositing money at a bank with a less convenient ATM network. But convenient ATM networks cost money.

You've been hanging around MMT for a long time, Ralph. I'm surprised you're still caught up on insisting that deposits are loaned out.

And depositors are not investors.

9:32 AM  
Blogger Ralph Musgrave said...

Neil,

“In other words via government sector spending injections”. Nope. Once the Monetary Policy Committee (or the equivalent committee that would decide how much stimulus is warranted under full reserve) decided that $X of extra money creation and spending was in order, it would be entirely up to POLITICIANS to decide how to spend that money. The extra spending COULD TAKE the form of extra public spending. But equally it could take the form of tax cuts.

In fact that’s little different to the existing system: i.e. stimulus over the last three years or so has been a mixture of extra public spending and tax cuts.

Re the need to withdraw money via tax, yes that would be needed from time to time. Though (as with the existing system) it would basically be a case of deficits about nine years out of ten.

Re your last paragraph, the fact that banks act as intermediaries DOES NOT NECESSARILY mean they create money. In fact over the last year or so, thanks to deleveraging, banks created virtually no new money in the UK. But they’ve continued acting as intermediaries haven’t they? As distinct from what banks have ACTUALLY DONE over the last year, it would be easy to set up a system in which banks act as intermediaries, but don’t create money.

Winter,

I’m baffled as why you think “If a bank goes out of business, investors (equity holders and bond holders) are large enough to bear the entire cost of the failure.” Lehmans was leveraged to the tune of about 30:1 when it failed, and Basle III is proposing similar leverage levels, with perhaps another 3% of loss absorbers in the form of bond holders: call that a total of 6%. That means the loans and investments made by a bank lonely have to fall in value by 6%, and the bank is technically insolvent or “balance sheet insolvent”.

I.e. in the event of failure depositors would lose as well, were it not for FDIC.

“That didn't happen. Neither equity holders nor bond holders were wiped out.” You bet they weren’t wiped out. That’s because the financial and political elite in the US and Europe are hand in glove. I.e. the political elite robs taxpayers in order to save bank shareholders and bondholders.

Next, you claim that depositors are not investors: they are simply people whose cash has been attracted to a bank because the bank wants the cash. I fully agree that depositors are not investors under the existing system. But what full reservers like me argue is that they SHOULD BE treated as investors. Reasons are thus.

There is absolutely no way a bank can fund interest payments to depositors other than by lending on or investing depositors’ money. Thus banks in their present form are a system under which depositors can gain the advantages of investing (i.e. get interest) WITHOUT any of the normal downside risk that goes with investing. And who bears the risk? Someone has to. Well to some extent it’s bank shareholders and bondholders, but ultimately the taxpayer carries the risk when things go seriously wrong.

No - correction. Given that the political and financial elite are (to repeat) hand in glove, bank shareholders and bondholders carry precious little risk (or at least less than they ought to).

So to summarise, the present system lets depositors gain the advantages of being investors without their carrying the risk: the risk is carried by the taxpayer. Now that’s a subsidy of the entire banking system, and I’m not in favour of subsidising a system that is supposed to be commercially viable.

12:40 AM  
Blogger Neil Wilson said...

"Once the Monetary Policy Committee (or the equivalent committee that would decide how much stimulus is warranted under full reserve) decided that $X of extra money creation and spending was in order, it would be entirely up to POLITICIANS to decide how to spend that money. The extra spending COULD TAKE the form of extra public spending. But equally it could take the form of tax cuts."

That's exactly what I said. The point being that it is government sector injections that is causing things to happen and nothing else.

And you have not addressed the democratic deficit of having the system driven by the Gods of the MPC.

They screwed up in 2008 and are largely still in post. Why?

Parliament should decide what is to be spent or injected for the good of the nation.

Technocratic dictatorship is not an acceptable system.

" it would be easy to set up a system in which banks act as intermediaries, but don’t create money."

It really isn't, and the evidence of the UK building societies demonstrates that in spades.

No lender ever rings down to the cash department to see if there is any money left. They always sell to a price and always will do.

I promise you that the dynamic system effects of this will be a consolidation of financial institutions - which will be triggered by institutions forcing the system to accommodate their own expansion by causing systemic shortages elsewhere.

Which is no doubt why big money is backing this sort of scheme. It's guaranteed to eliminate smaller lenders via systemic cash flow shortages and put up massive barriers to entry in the lending market.

All I see is a bunch of people trying once again to try and force fit the real world into their model Procrustean style. Systemically it is much better to develop a process that works with the natural tendency of institutions if you want to keep those institutions.

If you want a 'save before you lend' structure then you have to go to a matched lending process where the lending banks act as agent rather than principal - Zopa style.

1:07 AM  
Blogger Ralph Musgrave said...

Neil,

Re your first two paragraphs – sorry – I thought you were classifying public spending as an “injection” but not tax cuts. Assuming both are classified as injections, then I agree: obviously it’s injections that bring stimulus. So what are we arguing about there? The argument is over WHO DECIDES on the level of stimulus and how it’s effected, no? On which point…..

Re your idea that politicians rather than central banks should decide on the amount of stimulus, the huge and widely accepted problem there is that politicians resort to the printing press (particularly just before elections) to ensure they’re returned to office. That’s why (I think like most people) I favour central banks with a degree of independence. And under full reserve, exactly applies: the amount of stimulus would be decided, at least in part, by an independent committee. In fact in the UK (like some other countries) we now have TWO independent committees: the Monetary Policy Committee and the Office for Budget Responsibility.

Re UK building societies, you claim that lenders (banks or building societies) lend without bothering to see if they’ve got funds for such borrowing. Quite right. That’s how the existing system works. Full reservers say it shouldn’t work that way. In simply telling us how the existing system works, you aren’t telling full reservers anything they didn’t already know.

Next, I completely fail to see why full reserve would “guaranteed to eliminate smaller lenders…”. Quite the reverse. Under the PRESENT SYSTEM, it’s difficult for small lenders to engage in the above “bank and building society” activity, i.e. lending without bothering about whether they actually got funds to lend: reason is that a very large proportion of anything they lend gets deposited at other institutions.

In contrast, when a large bank lends money into existence, a significant proportion gets deposited back into the “large bank”.

That advantage that large institutions have would be eliminated under full reserve: i.e. EVERYONE would play by the same rule, which is that you cannot lend unless you’ve got funds to lend.

Of course actually enforcing that rule takes some doing. But given that governments when they really want to can enforce a 10% reserve requirement on commercial banks, I don’t see that enforcing a 20%, 50% or 100% requirement is too difficult.



2:12 AM  
Blogger Neil Wilson said...

"But given that governments when they really want to can enforce a 10% reserve requirement on commercial banks, I don’t see that enforcing a 20%, 50% or 100% requirement is too difficult."

That's because you've never worked in a financial institution and don't understand how the loans sales pipeline system works, how long it takes and what information that provides to the Treasury department.

You cannot enforce a borrow before you lend criteria, because you don't actually need the money until the last moment. Ahead of that is a ton of information that tells you how much you need and what price that has to be at.

And if I have brand power than I can sell loans at at a higher price and offer better deposit rates with shorter maturities. That's means I can drain weaker competitors very quickly, and without maturity matching they quickly cannot cover their loan base.

"UK building societies, you claim that lenders (banks or building societies) lend without bothering to see if they’ve got funds for such borrowing. Quite right. That’s how the existing system works"

No, that's how a 100% system works. Prior to deregulation UK building societies were 100% constrained - they had to have the money in their current account to do any transfers and couldn't lend otherwise since they were barred from offering current accounts. Internal transfers didn't happen. It had to be attracted back out of the general circulation.

Halifax got to be the bigger than all the other building societies put together under a funding constrained system, and it didn't do that by accident.

It did it by using brand power, forward selling ahead of funding and cross subsidisation with add on products.

The massive consolidation of the building society movement once the 'come back next month' process was dropped for the aggressive selling approach should be a warning.

2:39 AM  
Blogger Ralph Musgrave said...

Neil,

If “brand power” is so important, how come small banks in the U.S. weren’t driven out of business long ago? Banking is like many other industries: there is always a place for small local firms that know their local market better than bigger institutions.

Re your “don't actually need the money until the last moment” point, that is not of much importance. Certainly there’s always the option for a bank under 100% reserve (or any other reserve figure) to skate on thin ice and issue a loan ON THE EXPECTATION that funds will flow in in the next 48 hours or so to cover the loan. But that has nothing to do with whether or not the total amount loaned by a bank can be controlled by the central bank. The way to do it (which as I understand it is how 10% reserve requirements are actually enforced) is simply to require commercial banks to make regular returns to the central bank giving total amounts loaned, deposited, etc . And those totals (under full reserve) should not exceed what each commercial bank has deposited at the central bank.

Plus the central bank needs to do spot checks on commercial banks’ books to see whether their returns tie up with their books.

Moreover, the Chinese are currently keen on reserve requirements as a means of controlling commercial banks (like we were a few decades ago). Are they totally deluded? Of course there are problems in chasing around after shadow banks and illegal banks. But enforcing any law always involves costs.

Now for your last point (about Halifax, etc): I agree that those institution used to operate on a 100% reserve basis, and then slid into fractional reserve habits. I.e. they made the amazing discovery, noticed by London goldsmiths over a century earlier, that creating money out of thin air and lending it out is profitable.

“The massive consolidation of the building society movement once the 'come back next month' process was dropped for the aggressive selling approach should be a warning.” You are saying, as I understand you, that fractional reserve bolsters the consolidation process. My answer is: “too right”. Reason is that under fractional reserve, the TBTF subsidy is inevitable, and everyone knows government will rescue big lenders but not small ones.

That form of bending the rules in favour of big lenders would not occur under full reserve.

8:39 AM  

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